**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

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**FORM 10-Q**

 
| **(Mark One)**                                                                                                                                       |
|------------------------------------------------------------------------------------------------------------------------------------------------------|
| **ý**                                                                                                                                           | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                 |
| **For the quarterly period ended March 31,  2004**                                                                                              |
|                                                                                                                                                 |
| **OR**                                                                                                                                               |
|                                                                                                                                                 |
| **o**                                                                                                                                                | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                 |
| **For the transition period from             to         ** |
|                                                                                                                                                 |
| **COMMISSION  FILE NUMBER 000-29661**                                                                                                                |

 

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| **UTSTARCOM, INC.**                                |
|---------------------------------------------------------|
| (Exact name of Registrant as specified in  its charter) |

 

| **DELAWARE**                                                                                 |   | **52-1782500**                       |
|----------------------------------------------------------------------------------------------|--------|--------------------------------------|
| (State of Incorporation)                                                                     |   | (I.R.S. Employer Identification No.) |
|                                                                                         |   |                                 |
| **1275 HARBOR BAY PARKWAY,  ALAMEDA, CALIFORNIA**                                            |   | **94502**                            |
| (Address of principal executive  offices)                                                    |   | (zip code)                           |
|                                                                                         |   |                                 |
| Registrant’s  telephone number, including area code:  **(510) 864-8800** |

 

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Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.  Yes   ý  No   o

 

Indicate by check mark whether the Registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act of 1934).  Yes   ý  No   o

 

As of May 4, 2004 there were 113,795,336 shares of the registrant’scommon stock outstanding, par value $0.00125.

 

 

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**TABLE OF CONTENTS**

 
| **PART I.**  | **FINANCIAL INFORMATION**                                                                                                    |
|--------------|------------------------------------------------------------------------------------------------------------------------------|
|         |                                                                                                                         |
| Item 1.      | Condensed  Consolidated Financial Statements                                                                                 |
|         |                                                                                                                         |
|         | Condensed Consolidated Balance Sheets as of  March 31, 2004 (unaudited) and December 31, 2003                      |
|         |                                                                                                                         |
|         | Condensed Consolidated Statements of  Operations for the three month periods ended March 31, 2004 and 2003  (unaudited) |
|         |                                                                                                                         |
|         | Condensed Consolidated Statements of Cash  Flows for the three month periods ended March 31, 2004 and 2003  (unaudited) |
|         |                                                                                                                         |
|         | Notes to Condensed Consolidated Financial  Statements (unaudited)                                                            |
|         |                                                                                                                         |
| Item 2.      | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                  |
|         |                                                                                                                         |
| Item 3.      | Quantitative  and Qualitative Disclosures about Market Risk                                                                  |
|         |                                                                                                                         |
| Item 4.      | Controls  and Procedures                                                                                                     |
|         |                                                                                                                         |
| **PART II.** | **OTHER INFORMATION**                                                                                                        |
|         |                                                                                                                         |
| Item 1.      | Legal Proceedings                                                                                                            |
|         |                                                                                                                         |
| Item  2.     | Changes  in Securities, Use of Proceeds and Issuer Purchases of Equity Securities                                            |
|         |                                                                                                                         |
| Item 3.      | Defaults Upon Senior Securities                                                                                              |
|         |                                                                                                                         |
| Item 4.      | Submission of Matters to a Vote of Security  Holders                                                                         |
|         |                                                                                                                         |
| Item 5.      | Other  Information                                                                                                           |
|         |                                                                                                                         |
| Item 6.      | Exhibits  and Reports on Form 8-K                                                                                       |
|         |                                                                                                                         |
|         | Signatures                                                                                                                   |
|         |                                                                                                                         |
|         | Exhibit Index                                                                                                                |

 

2

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**PART I****—FINANCIAL INFORMATION**

 

**ITEM 1****—CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**UTSTARCOM, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS(UNAUDITED)**

**(In thousands, except share and per sharedata)**

 
|                                                                                                                                                                                    |   | **March 31,  2004** |      | **December 31,  2003** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|-----------|-----------------------------|--------|
|                                                                                                                                                                                    |   |                     |      |                        |   |
| **ASSETS**                                                                                                                                                                              |   |                     |      |                        |   |
| Current assets:                                                                                                                                                                         |   |                     |      |                        |   |
| Cash and cash equivalents                                                                                                                                                               |   | $                        | 724,939   |                        | $      | 373,974 |   |
| Short-term investments                                                                                                                                                                  |   | 41,330                   |      | 48,617                      |   |
| Accounts receivables, net of allowances for  doubtful accounts of $37,084 and $31,172 at March 31, 2004 and  December 31, 2003, respectively                                  |   |                     |      |                        |   |
| Accounts receivables, related parties                                                                                                                                                   |   | 29,797                   |      | 43,944                      |   |
| Notes receivable                                                                                                                                                                        |   | 43,824                   |      | 11,362                      |   |
| Inventories                                                                                                                                                                             |   | 318,079                  |      | 257,038                     |   |
| Deferred costs/Inventories at customer  sites under contracts                                                                                                                           |   | 426,240                  |      | 558,977                     |   |
| Prepaids                                                                                                                                                                                |   | 114,669                  |      | 136,262                     |   |
| Restricted cash and short-term investments                                                                                                                                              |   | 30,864                   |      | 24,404                      |   |
| Other current assets                                                                                                                                                                    |   | 54,628                   |      | 52,408                      |   |
| Total current assets                                                                                                                                                                    |   | 2,187,047                |      | 1,831,907                   |   |
| Property, plant and equipment, net                                                                                                                                                      |   | 200,762                  |      | 186,076                     |   |
| Long-term investments                                                                                                                                                                   |   | 24,101                   |      | 24,066                      |   |
| Goodwill                                                                                                                                                                                |   | 100,180                  |      | 100,180                     |   |
| Intangible assets, net                                                                                                                                                                  |   | 42,878                   |      | 45,753                      |   |
| Other long-term assets                                                                                                                                                                  |   | 40,836                   |      | 38,976                      |   |
| Total assets                                                                                                                                                                            |   | $                        | 2,595,804 |                        | $      | 2,226,958 |   |
|                                                                                                                                                                                    |   |                     |      |                        |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                           |   |                     |      |                        |   |
| Current liabilities:                                                                                                                                                                    |   |                     |      |                        |   |
| Accounts payable                                                                                                                                                                        |   | $                        | 288,017   |                        | $      | 251,176 |   |
| Income taxes payable                                                                                                                                                                    |   | 26,397                   |      | 16,780                      |   |
| Customer advances                                                                                                                                                                       |   | 302,255                  |      | 458,654                     |   |
| Deferred revenue                                                                                                                                                                        |   | 57,209                   |      | 44,958                      |   |
| Other current liabilities                                                                                                                                                               |   | 175,857                  |      | 173,139                     |   |
| Total current liabilities                                                                                                                                                               |   | 849,735                  |      | 944,707                     |   |
|                                                                                                                                                                                    |   |                     |      |                        |   |
| Convertible subordinated notes                                                                                                                                                          |   | 402,500                  |      | 402,500                     |   |
| Total liabilities                                                                                                                                                                       |   | 1,252,235                |      | 1,347,207                   |   |
|                                                                                                                                                                                    |   |                     |      |                        |   |
| Commitments and contingencies (Note 17)                                                                                                                                                 |   |                     |      |                        |   |
| Minority interest in consolidated  subsidiaries                                                                                                                                         |   | 610                      |      | 560                         |   |
| Stockholders’ equity:                                                                                                                                                              |   |                     |      |                        |   |
| Common stock: $0.00125 par value;  authorized: 750,000,000 shares; issued and outstanding: 114,368,691 and  104,272,477 at March 31, 2004 and December 31, 2003, respectively |   | 144                      |      | 131                         |   |
| Additional paid-in capital                                                                                                                                                              |   | 1,115,113                |      | 653,624                     |   |
| Deferred stock compensation                                                                                                                                                             |   | (7,484                   | )         | (7,761                      | )      |
| Retained earnings                                                                                                                                                                       |   | 231,326                  |      | 229,777                     |   |
| Accumulated other comprehensive income                                                                                                                                                  |   | 3,860                    |      | 3,420                       |   |
| Total stockholders’ equity                                                                                                                                                         |   | 1,342,959                |      | 879,191                     |   |
| Total liabilities, minority interest and  stockholders’ equity                                                                                                                     |   | $                        | 2,595,804 |                        | $      | 2,226,958 |   |

 

See accompanying notes to condensed consolidatedfinancial statements.

 

3

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**UTSTARCOM, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS (UNAUDITED)**

**(In thousands, except per share data)**

 
|                                                        |   | **Three  months ended March 31,** |    |
|-------------------------------------------------------------|--------|----------------------------------------|---------|
|                                                        |   | **2004**                               |    | **2003** |   |
|                                                        |   |                                   |    |   |   |
| Net sales                                                   |   |                                   |    |   |   |
| Unrelated parties                                           |   | $                                      | 610,731 |   | $ | 272,004 |   |
| Related parties                                             |   | 11,561                                 |    | 58,516 |   |
|                                                        |   | 622,292                                |    | 330,520 |   |
|                                                        |   |                                   |    |   |   |
| Cost of sales                                               |   | 446,258                                |    | 217,835 |   |
| Gross profit                                                |   | 176,034                                |    | 112,685 |   |
| Operating expenses:                                         |   |                                   |    |   |   |
| Selling, general and administrative                         |   | 66,943                                 |    | 37,583 |   |
| Research and development                                    |   | 45,658                                 |    | 26,812 |   |
| In-process research and development                         |   | —                                 |    | 1,320 |   |
| Amortization of intangible assets                           |   | 2,973                                  |    | 695 |   |
| Total operating expenses                                    |   | 115,574                                |    | 66,410 |   |
|                                                        |   |                                   |    |   |   |
| Operating income                                            |   | 60,460                                 |    | 46,275 |   |
| Interest income                                             |   | 1,354                                  |    | 943 |   |
| Interest expense                                            |   | (1,082                                 | )       | (639 | ) |
| Other income, net                                           |   | 8,785                                  |    | 4,186 |   |
| Equity in loss of affiliated companies                      |   | (997                                   | )       | (975 | ) |
| Income before income taxes and minority  interest           |   | 68,520                                 |    | 49,790 |   |
| Income tax expense                                          |   | 13,704                                 |    | 12,447 |   |
| Minority interest in earnings of  consolidated subsidiaries |   | (50                                    | )       | — |   |
|                                                        |   |                                   |    |   |   |
| Net income                                                  |   | $                                      | 54,766  |   | $ | 37,343 |   |
|                                                        |   |                                   |    |   |   |   |   |
| Basic earnings per share                                    |   | $                                      | 0.48    |   | $ | 0.35 |   |
|                                                        |   |                                   |    |   |   |   |   |
| Diluted earnings per share                                  |   | $                                      | 0.40    |   | $ | 0.33 |   |
|                                                        |   |                                   |    |   |   |   |   |
| Weighted average shares used in per-share  calculation:     |   |                                   |    |   |   |
|                                                        |   |                                   |    |   |   |
| •  Basic                                               |   | 114,614                                |    | 107,358 |   |
|                                                        |   |                                   |    |   |   |
| •  Diluted                                             |   | 139,325                                |    | 111,953 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

4

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**UTSTARCOM, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS (UNAUDITED)**

**(In thousands)**

 
|                                                                          |   | **Three  months ended March 31,** |    |
|-------------------------------------------------------------------------------|--------|----------------------------------------|---------|
|                                                                          |   | **2004**                               |    | **2003** |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                         |   |                                   |    |   |   |
| Net income                                                                    |   | $                                      | 54,766  |   | $ | 37,343 |   |
| Adjustment to reconcile net income to net  cash used in operating activities: |   |                                   |    |   |   |
| Depreciation and amortization                                                 |   | 16,438                                 |    | 7,910 |   |
| Non-qualified stock option exercise tax  benefits                             |   | 2,862                                  |    | 1,449 |   |
| Net loss on sale of assets                                                    |   | 190                                    |    | 47 |   |
| In-process research and development costs                                     |   | —                                 |    | 1,320 |   |
| Amortization of debt issuance costs                                           |   | 582                                    |    | 201 |   |
| Warrants adjustment to fair value                                             |   | 226                                    |    | 80 |   |
| Loss on sale of investment                                                    |   | —                                 |    | 80 |   |
| Net gain on long-term investments                                             |   | (34                                    | )       | — |   |
| Stock compensation expense                                                    |   | 77                                     |    | 715 |   |
| Provision for doubtful accounts                                               |   | 6,252                                  |    | 8,214 |   |
| Inventory provision                                                           |   | 9,439                                  |    | 2,495 |   |
| Equity in loss of affiliated companies                                        |   | 997                                    |    | 975 |   |
| Deferred income taxes                                                         |   | (2,236                                 | )       | (842 | ) |
| Minority interest in earnings of  consolidated subsidiary                     |   | 50                                     |    | — |   |
| Changes in operating assets and  liabilities:                                 |   |                                   |    |   |   |
| Accounts receivable                                                           |   | (69,862                                | )       | (41,431 | ) |
| Inventories                                                                   |   | (70,480                                | )       | (131,067 | ) |
| Deferred costs/Inventories at customer  sites under contracts                 |   | 132,737                                |    | (241,230 | ) |
| Other current and non-current assets                                          |   | (13,279                                | )       | (52,095 | ) |
| Accounts payable                                                              |   | 36,841                                 |    | 219,905 |   |
| Income taxes payable                                                          |   | 9,617                                  |    | 5,922 |   |
| Customer advances                                                             |   | (156,399                               | )       | 87,245 |   |
| Deferred revenue                                                              |   | 12,251                                 |    | 5,715 |   |
| Other current liabilities                                                     |   | 1,671                                  |    | 12,206 |   |
| Net cash used in operating activities                                         |   | (27,294                                | )       | (74,843 | ) |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                         |   |                                   |    |   |   |
| Additions to property, plant and equipment                                    |   | (27,740                                | )       | (15,169 | ) |
| Investment in affiliates                                                      |   | (1,000                                 | )       | (3,074 | ) |
| Purchase of businesses, net of cash  acquired                                 |   | —                                 |    | (1,292 | ) |
| Purchase of intangible assets                                                 |   | (125                                   | )       | — |   |
| Change in restricted cash                                                     |   | (58                                    | )       | (2,377 | ) |
| Purchase of short-term investments                                            |   | (50,575                                | )       | (16,319 | ) |
| Proceeds from sale of short-term  investments                                 |   | 51,460                                 |    | 91,876 |   |
| Net cash (used in) provided by investing  activities                          |   | (28,038                                | )       | 53,645 |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                         |   |                                   |    |   |   |
| Issuance of stock, net of expenses                                            |   | 9,224                                  |    | 4,026 |   |
| Purchase of bond hedge and call option                                        |   | —                                 |    | (43,792 | ) |
| Net proceeds from borrowing                                                   |   | —                                 |    | 391,431 |   |
| Repurchase of stock                                                           |   | (78,155                                | )       | — |   |
| Proceeds from equity offering                                                 |   | 474,554                                |    | — |   |
| NET CASH PROVIDED BY FINANCING ACTIVITIES                                     |   | 405,623                                |    | 351,665 |   |
| Effect of exchange rate changes on cash                                       |   | 674                                    |    | (270 | ) |
| Net increase in cash and cash equivalents                                     |   | 350,965                                |    | 330,197 |   |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF  PERIOD                             |   | 373,974                                |    | 231,944 |   |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                    |   | $                                      | 724,939 |   | $ | 562,141 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

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**UTSTARCOM, INC.**

**NOTESTO CONDENSED****CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**

 

**1.****                                      BASISOF PRESENTATION:**

 

The accompanying unaudited condensed consolidated financial statementsinclude the accounts of UTStarcom, Inc. (the “Company”) and its wholly andmajority owned subsidiaries. All significant intercompany accounts andtransactions have been eliminated in the preparation of the condensedconsolidated financial statements. The minority interests in consolidatedsubsidiaries and equity in affiliated companies are shown separately in thecondensed consolidated financial statements. Investments in affiliatedcompanies are accounted for using the cost or equity method, as applicable.

 

The accompanying financial statements as of March 31, 2004 and forthe three months ended March 31, 2004 and 2003 have been prepared by theCompany, without audit, pursuant to the rules and regulations of the Securitiesand Exchange Commission (“SEC”). Certain information and footnote disclosuresnormally included in financial statements prepared in accordance with generallyaccepted accounting principles have been condensed or omitted pursuant to suchrules and regulations. The December 31, 2003 balance sheet was derivedfrom audited financial statements, but does not include all disclosuresrequired by generally accepted accounting principles. These condensedconsolidated financial statements should be read in conjunction with theCompany’s audited December 31, 2003 financial statements, including thenotes thereto, and the other information set forth in the Company’s AnnualReport on Form 10-K for the year ended December 31, 2003.

 

In the opinion of management, the accompanying condensed consolidatedfinancial statements reflect all adjustments (consisting of only normalrecurring adjustments) considered necessary for a fair presentation of the Company’sfinancial condition, the results of its operations and its cash flows for theperiods indicated. The results of operations for the three months endedMarch 31, 2004 are not necessarily indicative of the operating results forthe full year.

 

**2.****                                      REVENUERECOGNITION:**

 

Revenues from sales of telecommunications equipment are recognized whenpersuasive evidence of an arrangement exists, delivery of the product hasoccurred, customer acceptance has been obtained, the fee is fixed ordeterminable and collectability is reasonably assured. If the payment due fromthe customer is not fixed or determinable due to extended payment terms,revenue is recognized as payments become due from the customer, assuming allother criteria for revenue recognition are met. Any payments received prior torevenue recognition are recorded as customer advances. Normal payment termsdiffer for various reasons amongst different customer regions, depending uponcommon business practices for customers within a region. Shipping and handlingcosts are recorded as revenues and costs of revenues. Any expected losses oncontracts are recognized immediately.

 

Sales may be generated from complex contractual arrangements thatrequire significant revenue recognition judgments, particularly in the areas ofmultiple element arrangements. Where multiple elements exist in an arrangement,the arrangement fee is allocated to the different elements based uponverifiable objective evidence of the fair value of the elements, as governedunder EITF 00-21, and SEC Staff Accounting Bulletin No. 104 “SAB 104.”Multiple element arrangements primarily involve the sale of Personnel AccessSystems (“PAS”), a family of wireless access handsets, wireless consumerproducts and core infrastructure equipment or Internet Protocol-based PAS(“iPAS”) wireless access systems that employ micro cell radio technology andspecialized handsets, allowing service providers to offer subscribers bothmobile and fixed access to telephone services. These multiple element arrangementsinclude the sale of PAS or iPAS equipment with handsets, installation andtraining and the provision of such equipment to different locations for thesame customer. Revenue is recognized as each element is earned, namely uponinstallation and acceptance of equipment or delivery of handsets, provided thatthe fair value of the undelivered element(s) has been determined, the deliveredelement has stand-alone value, there is no right of return on deliveredelement(s), and the vendor is in control of the undelivered element(s).

 

Final acceptance is required for revenue recognition when installationservices are not considered perfunctory. Final acceptance indicates that thecustomer has fully accepted delivery of equipment and the Company is entitledto the full payment. The Company will not recognize revenue before finalacceptance is granted by the customer if acceptance is considered substantiveto the transaction. Additionally, the Company does not recognize revenue whencash payments are received from customers for transactions that do not have thecustomer’s final acceptance. The Company records these cash receipts ascustomer advances, and defers revenue recognition until final acceptance isreceived.

 

Where multiple elements exist in an arrangement that includes softwareand the software is considered more than incidental to the equipment orservices in the arrangement, software and software-related elements arerecognized under the provisions of Statement of Position 97-2, as amended, andEmerging Issues Task Force Issue No. 03-05. The Company allocates revenues toeach element of software arrangements based on vendor-specific objectiveevidence (“VSOE”). VSOE of each element is based on the price charged when thesame element is sold separately. The Company uses the residual method torecognize revenue when an arrangement includes one or more elements to bedelivered at a future date and VSOE of the fair value of all the undeliveredelements exists. Under the residual

 

6

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method, the fair value of the undelivered elements is deferred and theremaining portion of the arrangement fee is recognized as revenue. If evidenceof fair value of one or more undelivered elements does not exist, revenue isdeferred and recognized when delivery of those elements occurs or when fairvalue can be established.

 

The Company recognizes revenue for system integration, installation andtraining upon completion of performance if all other revenue recognitioncriteria are met. Other service revenue, such as that related to maintenanceand support contracts, is recognized ratably over the contract term. Revenuesfrom services were less than 10% of revenues for all periods.

 

The Company also sells products through resellers. Revenue is generallyrecognized when the standard price protection period, which ranges from 30 to90 days, has lapsed. If collectability cannot be reasonably assured in areseller arrangement, revenue is recognized upon sell-through to the endcustomer and receipt of cash. There may be additional obligations in resellerarrangements such as inventory rotation, or stock exchange rights on theproduct. As such, revenue is recognized in accordance with Statement ofFinancial Accounting Standards No. 48 “Revenue Recognition When Right ofReturn Exists” (“SFAS 48”). The Company has developed reasonable estimates forstock exchanges. Estimates are derived from historical experience with similartypes of sales of similar products.

 

The assessment of collectability is also a factor in determiningwhether revenue should be recognized. The Company assesses collectability basedon a number of factors, including payment history and the credit-worthiness ofthe customer. The Company does not request collateral from its customers. Ininternational sales, the Company often requires letters of credit from itscustomers that can be drawn on demand if the customer defaults on its payment.If the Company determines that collection of a payment is not reasonablyassured, the Company recognizes revenue at the time collection becomesreasonably assured, which is generally upon receipt of cash.

 

Because of the nature of doing business in China and other emergingmarkets, the Company’s billings and/or customer payments may not correlate withthe contractual payment terms and the Company generally does not enforcecontractual payment terms prior to final acceptance. Accordingly, accountsreceivable are not booked until the Company recognizes the related customerrevenue.  Advances from customers arerecognized when the Company has collected cash from the customer, prior torecognizing revenue. Deferred revenue is recorded if there are undeliveredelements after final acceptance has been obtained.

 

The Company provides a warranty on its equipment and handset sales fora period generally ranging from one to three years from the time of finalacceptance. The Company provides for the expected cost of product warranties atthe time that revenue is recognized, based on an assessment of past warranty experience.

 

**3.****                                      EARNINGSPER SHARE:**

 

Basic earnings per share is computed by dividing net income availableto holders of common stockh by the weighted average number of shares of theCompany’s common stock outstanding during the period. Diluted earnings pershare is determined by adjusting net income as reported by the effect ofdilutive securities and increasing the number of shares by potentially dilutiveshares of common stock outstanding during the period. Potentially dilutiveshares of common stock consist of employee stock options, a written calloption, warrants and convertible subordinated notes.

 

The following is a summary of the calculation of basic and dilutedearnings per share (in thousands, except per share data):

 

7

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|                                                               |   | **Three  months ended March 31,** |   |
|--------------------------------------------------------------------|--------|----------------------------------------|--------|
|                                                               |   | **2004**                               |   | **2003** |   |
| Numerator:                                                         |   |                                   |   |   |   |
|                                                               |   |                                   |   |   |   |
| Net income (for basic EPS computation)                             |   | $                                      | 54,766 |   | $ | 37,343 |   |
|                                                               |   |                                   |   |   |   |
| Effect of Dilutive Securities 7/8%  Convertible Subordinated Notes |   | 917                                    |   | — |   |
|                                                               |   |                                   |   |   |   |
| Net income adjusted for dilutive securities                        |   | $                                      | 55,683 |   | $ | 37,343 |   |
|                                                               |   |                                   |   |   |   |
| Denominator:                                                       |   |                                   |   |   |   |
|                                                               |   |                                   |   |   |   |
| Shares used to compute basic EPS                                   |   | 114,614                                |   | 107,358 |   |
| Dilutive common stock equivalent shares:                           |   |                                   |   |   |   |
| Stock options                                                      |   | 6,326                                  |   | 3,937 |   |
| Written call option                                                |   | 1,046                                  |   | — |   |
| Conversion of convertible subordinated  notes                      |   | 16,919                                 |   | — |   |
| Warrants                                                           |   | 30                                     |   | 28 |   |
| Other                                                              |   | 390                                    |   | 630 |   |
| Shares used to compute diluted EPS                                 |   | 139,325                                |   | 111,953 |   |
| Basic earnings per share                                           |   | $                                      | 0.48   |   | $ | 0.35 |   |
| Diluted earnings per share                                         |   | $                                      | 0.40   |   | $ | 0.33 |   |

 

Certain potential shares related to employee stock options and warrantsoutstanding during the three months ended March 31, 2004 and 2003 wereexcluded in the diluted per share computations, since their exercise priceswere greater than the average market price of the Company’s common stock duringthe period and, accordingly, their effect is anti-dilutive. For the threemonths ended March 31, 2004 and 2003, these shares totaled1.6 million with a weighted average exercise price of $38.04 per share and5.6 million shares with a weighted average exercise price of $21.80 pershare, respectively. The Company has outstanding warrants for issuance of32,000 shares at the exercise price of $2.50 per share.

 

On March 31, 2004, each of the Company’s7/8% convertiblesubordinated notes outstanding was eligible for conversion into shares ofcommon stock. For each $1,000 of aggregate principal amount of notes converted,the Company will deliver approximately 42.0345 shares of common stock, if theCompany’s stock price exceeds a specified threshold. At March 31, 2004,the closing price of the Company’s common stock exceeded the specifiedthreshold, which had the effect of increasing the denominator for dilutedearnings per share by 16.9 million. Additionally, during the three monthsended March 31, 2004, the average price of the Company’s stock exceededthe specified strike prices of the convertible bond hedge and call optiontransactions that the Company entered into to reduce the potential dilutionfrom conversion of the notes. Both the bond hedge and call option transactionsmay be settled at the Company’s option either in cash or net shares and expireon March 1, 2008. Using the treasury stock method, under Statement ofFinancial Accounting Standards No. 128, “Earnings Per Share”(“SFAS 128”), this would have the effect of decreasing the denominator fordiluted earnings per share by 5.1 million shares for the bond hedgetransaction, and increasing the denominator for diluted earnings per share by1.0 million shares for the call option transaction. However, only thedilutive effect of the 1.0 million shares with respect to the call optiontransaction is included in the Company’s diluted earnings per share calculationabove. The convertible bond hedge, under SFAS 128, is alwaysanti-dilutive.

 

The net income for the diluted EPS computation reflects the reductionin interest expense of $0.9 million for the three months endedMarch 31, 2004, that would result from an assumed conversion of the 7/8% convertible subordinatednotes.

 

**4.****                                      STOCK-BASEDCOMPENSATION:**

 

The Company accounts for employee stock option grants in accordancewith Accounting Principles Board Opinion No. 25, “Accounting for StockIssued to Employees” (“APB 25”) and has adopted the disclosure-only alternativeof SFAS No. 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation” (“SFAS 123”). Under APB 25, compensation expense isbased on the difference, if any, on the date of grant between the fair value ofthe common stock and the exercise price of the option.

 

The fair value of warrants, options or stock exchanged for servicesfrom non-employees is expensed over the period benefited. The warrants andoptions are valued using the Black-Scholes option-pricing model.

 

8

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The following table illustrates the effect on net income and earningsper share if the Company had applied the fair value recognition provisions ofSFAS No. 123 to stock-based employee compensation (in thousands, exceptper share data):

 
|                                                                                                                     |   | **Three  months ended March 31,** |   |
|--------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------|--------|
|                                                                                                                     |   | **2004**                               |   | **2003** |   |
| Basic                                                                                                                    |   |                                   |   |   |   |
| Net income:                                                                                                              |   |                                   |   |   |   |
| As reported                                                                                                              |   | $                                      | 54,766 |   | $ | 37,343 |   |
|                                                                                                                     |   |                                   |   |   |   |
| Add:   Stock-based employee compensation expense included in reported net  income, net of related tax effects       |   | 55                                     |   | 499 |   |
|                                                                                                                     |   |                                   |   |   |   |
| Deduct: Total compensation expense  determined under fair value based method for all awards, net of related tax  effects |   | (7,966                                 | )      | (6,315 | ) |
|                                                                                                                     |   |                                   |   |   |   |
| Pro forma net income                                                                                                     |   | $                                      | 46,855 |   | $ | 31,527 |   |
|                                                                                                                     |   |                                   |   |   |   |
| Basic income per share:                                                                                                  |   |                                   |   |   |   |
| As reported                                                                                                              |   | $                                      | 0.48   |   | $ | 0.35 |   |
| Pro forma                                                                                                                |   | $                                      | 0.41   |   | $ | 0.29 |   |
|                                                                                                                     |   |                                   |   |   |   |
| Diluted                                                                                                                  |   |                                   |   |   |   |
| Net income:                                                                                                              |   |                                   |   |   |   |
| As reported                                                                                                              |   | $                                      | 54,766 |   | $ | 37,343 |   |
|                                                                                                                     |   |                                   |   |   |   |
| Effect of dilutive securities 7/8%  Convertible subordinated notes                                                       |   | 917                                    |   | — |   |
|                                                                                                                     |   |                                   |   |   |   |
| Add:   Stock-based employee compensation expense included in reported net  income, net of related tax effects       |   | 55                                     |   | 499 |   |
|                                                                                                                     |   |                                   |   |   |   |
| Deduct: Total compensation expense  determined under fair value based method for all awards, net of related tax  effects |   | (7,966                                 | )      | (6,315 | ) |
|                                                                                                                     |   |                                   |   |   |   |
| Pro forma net income                                                                                                     |   | $                                      | 47,772 |   | $ | 31,527 |   |
|                                                                                                                     |   |                                   |   |   |   |
| Diluted income per share:                                                                                                |   |                                   |   |   |   |
| As reported                                                                                                              |   | $                                      | 0.40   |   | $ | 0.33 |   |
| Pro forma                                                                                                                |   | $                                      | 0.35   |   | $ | 0.29 |   |

 

**5.****                                      COMPREHENSIVEINCOME:**

 

The reconciliation of net income to comprehensive income for the threemonths ended March 31, 2004 and 2003 is as follows (in thousands):

 
|                                          |   | **Three  Months Ended March 31,** |   |
|-----------------------------------------------|--------|----------------------------------------|--------|
|                                          |   | **2004**                               |   | **2003** |   |
| Net income                                    |   | $                                      | 54,766 |   | $ | 37,343 |   |
| Unrealized gains (losses) on investments      |   | (233                                   | )      | 574 |   |
| Change in cumulative translation  adjustments |   | 674                                    |   | (34 | ) |
| Total comprehensive income                    |   | $                                      | 55,207 |   | $ | 37,883 |   |

 

9

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**6.****                                      CASH,CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS:**

 

Cash and cash equivalents consist of instruments with maturities ofthree months or less at the date of purchase. All of the Company’s short-terminvestments are classified as available-for-sale. There were noavailable-for-sale securities included in cash and cash equivalents atMarch 31, 2004 or December 31, 2003. Short-term investments, consistingof available-for-sale securities, were $41.3 million and $48.6 million atMarch 31, 2004 and December 31, 2003, respectively. Theseavailable-for-sale securities consist of government-backed notes, commercialpaper, floating rate corporate bonds and fixed income corporate bonds. Theseinvestments are recorded at fair value. Any unrealized holding gains or lossesare reported as a component of comprehensive income. Realized gains and lossesare reported in earnings.

 

The Company accepts bank notes receivable with maturity dates betweenthree and six months from its customers in China in the normal course ofbusiness. The Company may discount these notes with banking institutions inChina. A sale of these notes is reflected as a reduction of other currentassets and the proceeds of the settlement of these notes are included in cashflows from operating activities in the consolidated statement of cash flows.There were zero and $35.5 million of bank notes receivable sold during thethree months ended March 31, 2004 and 2003, respectively. These notes arenot included in the Company’s consolidated balance sheets as the criteria forsale treatment established by Statement of Financial Accounting StandardsNo. 140, “Accounting for Transfers and Servicing of Financial Assets andExtinguishment of Liabilities” (“SFAS 140”), has been met. UnderSFAS 140, upon a transfer, the transferor or entity must derecognizefinancial assets when control has been surrendered and the transferee obtainscontrol over the assets. In addition, the transferred assets have been isolatedfrom the transferor, beyond the reach of its creditors, and the transferee hasthe right, without conditions or constraints, to pledge or exchange the assetsit has received. The costs of settling or transferring these notes receivablewere insignificant for the three months ended March 31, 2003. Bank notesreceivable were $57.0 million and $11.5 million at March 31, 2004 andDecember 31, 2003, respectively.

 

**7.****                                      RESTRICTEDCASH AND SHORT-TERM INVESTMENTS:**

 

At March 31, 2004, the Company had restricted cash and short-terminvestments of $30.9 million primarily comprised of $26.9 million of restrictedshort-term investments for standby letters of credit and restricted cash of a$3.8 million time deposit required for Japanese tax purposes.  AtDecember 31, 2003, the Company had restricted cash and short-terminvestments of $24.4 million primarily comprised of $20.5 million of restrictedshort-term investments for standby letters of credit and restricted cash of a$3.7 million time deposit required for Japanese tax purposes.

 

The Company issues standby letters of credit primarily to supportinternational sales activities outside of China. When the Company submits a bidfor a sale, often the potential customer will require that the Company issue abid bond or a standby letter of credit to demonstrate its commitment throughthe bid process.  In addition, the Company may be required to issuestandby letters of credit as guarantees for advance customer payments uponcontract signing or performance guarantees. The standby letters of creditusually expire six to nine months from date of issuance without being drawn bythe beneficiary thereof.

 

**8.****                                      ACCOUNTSAND NOTES RECEIVABLE:**

 

The Company accepts commercial notes receivable with maturity datesbetween three and six months from its customers in China in the normal courseof business. The Company may discount these notes with banking institutions inChina. A sale of these notes is reflected as a reduction of notes receivableand the proceeds of the settlement of these notes are included in cash flowsfrom operating activities in the consolidated statement of cash flows. Therewere zero and $19.3 million of notes receivable sold during the three monthsended March 31, 2004 and 2003, respectively. These notes are not includedin the Company’s consolidated balance sheets as the criteria for sale treatmentestablished by SFAS 140, has been met. The costs of settling or transferringthese notes receivable were $0.1 million for the three months endedMarch 31, 2003, and were included in other income, net in the ConsolidatedStatements of Operations. Notes receivable available for sale were $43.8million and $11.4 million at March 31, 2004 and December 31, 2003,respectively.

 

**9.****                                      SUPPLEMENTALDISCLOSURES OF CASH FLOW INFORMATION:**

 
|                             |   | **Three  months ended March 31,** |   |
|----------------------------------|--------|----------------------------------------|--------|
| **(In thousands)**               |   | **2004**                               |   | **2003** |   |
|                             |   |                                   |   |   |   |
| Cash paid during the period for: |   |                                   |   |   |   |
| Interest                         |   | $                                      | 1,768  |   | $ | 103 |   |
| Income taxes                     |   | $                                      | 2,426  |   | $ | 4,833 |   |

 

10

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|                                                 |   | **Three  months ended March 31,** |   |
|------------------------------------------------------|--------|----------------------------------------|--------|
| **(in thousands)**                                   |   | **2004**                               |   | **2003** |   |
| Non-cash operating activities were as  follows:      |   |                                   |   |   |   |
| Accounts receivable transferred to notes  receivable |   | $                                      | 48,988 |   | $ | 29,347 |   |
|                                                      |        |                                        |        |  |  |  |  |

 

**10.****                               INVENTORIESAND DEFERRED COSTS/INVENTORIES AT CUSTOMER SITES UNDER CONTRACTS:**

 

As of March 31, 2004 and December 31, 2003, total inventoriesconsist of the following (in thousands):

 
|                                                              |   | **March 31,  2004** |    | **December 31,  2003** |   |
|-------------------------------------------------------------------|--------|--------------------------|---------|-----------------------------|--------|
|                                                              |   | **(in  thousands)**      |    |
| *Inventories*                                                     |   |                     |    |
| Raw materials                                                     |   | $                        | 71,163  |                        | $      | 66,753 |   |
| Work-in-process                                                   |   | 41,859                   |    | 51,116                      |   |
| Finished goods                                                    |   | 62,305                   |    | 48,206                      |   |
| Inventories at customer sites without  contracts (finished goods) |   | 142,752                  |    | 90,963                      |   |
|                                                              |   | $                        | 318,079 |                        | $      | 257,038 |   |
|                                                              |   |                     |    |                        |   |
| *Deferred  costs/Inventories at customer sites under contracts*   |   |                     |    |                        |   |
| Finished goods                                                    |   | $                        | 426,240 |                        | $      | 558,977 |   |

 

**11.****                               STOCKHOLDERS’EQUITY:**

 

OnJanuary 14, 2004, the Company sold 12.1 million shares of commonstock at $39.25 per share in a privately negotiated transaction to aninstitution, for net proceeds of approximately $474.6 million. The netproceeds are intended to fund strategic and general corporate activities,including, but not limited to, acquisitions, investments, working capital orcapital expenditures.

 

On March 12,2004, the Company’s Board of Directors approved a stock repurchase program,authorizing the Company’s repurchase of up to 5,000,000 shares of itsoutstanding common stock over a period of 6 months. The Board approved anadditional repurchase of 1,623,000 shares in a privately negotiated transactionwith an institution.  As ofMarch 31, 2004, the Company repurchased a total of approximately 2.6million shares under this program at an average price of $30.43 per share, fora total cash outflow of $78.2 million.

 

The Company had$9.2 million and $4.0 million of net proceeds from the exercise ofstock options for the three months ended March 31, 2004 and 2003,respectively.

** **

**12.****                               DEBT:**

 

The following represents the outstanding borrowings at March 31,2004 and December 31, 2003 (in thousands):

 
| **Note**                       |   | **Rate** |   | **Maturity**         |   | **March 31,  2004** |    | **December 31,  2003** |   |
|--------------------------------|--------|----------|--------|----------------------|--------|--------------------------|---------|-----------------------------|--------|
| Notes Payable                  |   | 0        | %      | April-June 2004 |   | $                        | 1,044   |                        | $      | 1 |   |
| Convertible Subordinated Notes |   | 7/8      | %      | March 1, 2008   |   | 402,500                  |    | 402,500                     |   |
| Total Debt                     |   |     |   |                 |   | $                        | 403,544 |                        | $      | 402,501 |   |
| Long-term debt                 |   |     |   |                 |   | 402,500                  |    | 402,500                     |   |
| Short-term debt                |   |     |   |                 |   | $                        | 1,044   |                        | $      | 1 |   |

 

The Company has available borrowing facilities of $390.5 millionas of March 31, 2004. $336.2 million of these facilities expire in2004 and $54.3 million of these facilities expire between 2008 and 2010with an interest rate of 6.21%, and the Company has not guaranteed any debt notincluded in the consolidated balance sheet.

 

Occasionally, the Company issues short-term notes payable to itsvendors in lieu of trade accounts payable. The payment terms are normally three to six months and are typicallynon-interest bearing.  The Company had$1.0 million of these notes at March 31, 2004 included in other currentliabilities.

 

On March 12, 2003, the Company completed anoffering of $402.5 million of convertible subordinated notes dueMarch 1, 2008 to qualified buyers pursuant to Rule 144A under theSecurities Act of 1933. The notes bear interest at a rate of 7/8% per annum andare convertible into the Company’s common stock at a conversion price of $23.79per share and are subordinated to all present and future senior debt of theCompany. Holders of the notes may convert their notes only if: (i) theprice of the Company’s common stock issuable upon conversion of a note reachesa specified threshold, (ii) specified corporate transactions occur, or(iii) the trading price for the notes falls below certain thresholds. Atthe initial conversion price, each $1,000 principal amount of notes will beconvertible into approximately 42.0345 shares of common stock.

 

11

----

 

Concurrent with the issuance of the convertible notes, the Companyentered into a convertible bond hedge and call option transaction at a cost of$43.8 million. The convertible bond hedge allows the company to purchase16,918,873 shares of its common stock at $23.79 per share from the other partyto the agreement. The written call option allows the holder to purchase16,918,873 shares of the Company’s common stock from the Company at $32.025 pershare. Both the bond hedge and call option transactions may be settled at theCompany’s option either in cash or net shares and expire on March 1, 2008.The Company recorded these instruments at cost, and their carrying value atMarch 31, 2004 approximates their original cost. The convertible bondhedge and call option transactions are expected to reduce the potentialdilution from conversion of the notes. The options have been included instockholders’ equity in accordance with the guidance in Emerging Issues TaskForce Issue No. 00-19, “Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock.”

 

**13.****                               WARRANTYOBLIGATIONS AND OTHER GUARANTEES:**

 

Warranty obligations are as follows (in thousands):

 
|                                              |   | **Three months ended  March 31,** |   |
|---------------------------------------------------|--------|----------------------------------------|--------|
|                                              |   | **2004**                               |   | **2003** | ** ** |
|                                              |   |                                   |   |   |   |
| Beginning of period                               |   | $                                      | 26,267 |   | $ | 13,297 |   |
| Accruals for warranties issued during the  period |   | 9,841                                  |   | 8,283 |   |
| Adjustments to accruals for changes in  estimates |   | 167                                    |   | (4,552 | ) |
| Settlements made during the period                |   | (6,751                                 | )      | (4,504 | ) |
| Balance at end of period                          |   | $                                      | 29,524 |   | $ | 12,524 |   |

 

Certain of the Company’s sales contracts include provisions under whichcustomers would be indemnified by the Company in the event of, among otherthings, a third-party claim against the customer for intellectual propertyrights infringement related to the Company’s products. There are no limitationson the maximum potential future payments under these guarantees. The Companyhas accrued no amounts in relation to these provisions as no such claims havebeen made and the Company believes it has valid, enforceable rights to theintellectual property embedded in its products.

 

The Company issues standby letters of credit primarily to supportinternational sales activities outside of China. When the Company submits a bidfor a sale, often the potential customer will require that the Company issue abid bond or a standby letter of credit to demonstrate its commitment throughthe bid process. In addition, the Company may be required to issue standby lettersof credit as guarantees for advance customer payments upon contract signing orperformance guarantees. The standby letters of credit usually expire six tonine months from date of issuance without being drawn by the beneficiarythereof.

 

**14.****                               LONG-TERMINVESTMENTS:**

 

The Company’s investments are as follows (in thousands):

 
|                                        |   | **March 31,  2004** |   | **December 31,  2003** |   |
|---------------------------------------------|--------|--------------------------|--------|-----------------------------|--------|
| Softbank China                              |   | $                        | 5,294  |                        | $      | 5,308 |   |
| Cellon International                        |   | 8,000                    |   | 8,000                       |   |
| Restructuring Fund No. 1                    |   | 1,838                    |   | 1,861                       |   |
| Global Asia Partners L.P.                   |   | 1,653                    |   | 1,653                       |   |
| Fiberxon Inc.                               |   | 3,000                    |   | 2,000                       |   |
| InterWave Communications International Ltd. |   | 2,795                    |   | 3,319                       |   |
| Joint Venture with Matsushita               |   | —                   |   | 517                         |   |
| Others                                      |   | 1,521                    |   | 1,408                       |   |
|                                        |   |                     |   |                        |   |
| Total                                       |   | $                        | 24,101 |                        | $      | 24,066 |   |

 

*Softbank China*

* *

The Company has a $5.3 million investment in Softbank China, aninvestment fund established by SOFTBANK CORP. focused on investments inInternet companies in China. This investment permits the Company to participatein the anticipated growth of Internet-related businesses in China. SOFTBANKCORP. and its related companies are significant stockholders of the Company.The Company’s investment constitutes 10% of the funding for Softbank China,with SOFTBANK CORP. contributing the remaining 90%. The fund has a separatemanagement team, and none of the Company’s employees are employed by the fund.Many of the fund’s investments are and will be in privately held companies,many of which are still in the start-up or development stages. Theseinvestments

 

12

----

 

are inherently risky as the markets for the technologies or productsthe companies have under development are typically in the early stages and maynever materialize. The Company accounts for this investment under the costmethod and recorded insignificant losses and losses of $0.1 million due to another than temporary decline in the carrying value of this investment duringthe three months ended March 31, 2004 and 2003, respectively.

 

*Restructuring Fund*

 

During fiscal 2002, the Company invested $2.0 million inRestructuring Fund No. 1, a venture capital investment limited partnershipestablished by SOFTBANK INVESTMENT CORP., an affiliate of SOFTBANK CORP.SOFTBANK America Inc., an entity affiliated with SOFTBANK CORP., is asignificant stockholder of the Company. The fund focuses on leveraged buyoutinvestments in companies in Asia undergoing restructuring or bankruptcyprocedures. The total fund offering is expected to be between approximately$150.0 million and $226.0 million, with each investor contributing aminimum of $0.8 million.

 

The fund has a separate management team, and none of the Company’semployees are employed by the fund. The Company accounts for this investmentunder the equity method of accounting. During the three months endedMarch 31, 2004 the Company recorded insignificant equity losses.  There were no gains or losses for the threemonths ended March 31, 2003.

 

*Global Asia Partners, L.P.*

 

In June 2002, the Company invested $1.0 million in GlobalAsia Partners L.P., and an additional $1.0 million in June 2003, witha commitment to invest up to a maximum of $5.0 million. The remainingamount is due at such times and in such amounts as shall be specified in one ormore future capital calls to be issued by the general partner. The fund size isanticipated to be $10.1 million and the fund was formed to make privateequity investments in private or pre-IPO technology and telecommunicationscompanies. The fund’s geographic focus is on technology investments in Asia, inparticular India and China. The Company accounts for this investment under theequity method of accounting. During the three months ended March 31, 2004and 2003, the Company recorded no losses associated with this investment.

 

*Interwave*

 

During 2002, the Company purchased approximately 5.8 millionshares of common stock of InterWave Communications, InternationalLtd. Inc., a technology company listed on Nasdaq, for approximately$3.0 million. In addition, the Company received warrants to purchase 2.0 millionshares of InterWave’s common stock at $0.21 per share. The Company’s holdingswere adjusted for a 1:10 reverse stock split on April 30, 2003, and were0.6 million shares of common stock and warrants to purchase0.2 million shares of InterWave’s common stock at $2.10 per share. Thewarrants were valued at $0.5 million at March 31, 2004, using theBlack-Scholes option-pricing model. The Company recorded a loss of $0.2 millionand $0.1 million for the three months ended March 31, 2004 and 2003, respectively,to reflect the decline in the fair value of the warrants. The Company recordedthe decrease in the carrying value of these common stock securities of$0.3 million and $0.2 million for the three months ended March 31,2004 and 2003, respectively, in other comprehensive income in equity.

 

*Matsushita*

 

In July, 2002, the Company entered into a joint venture agreement withMatsushita Communication Industrial Co., Ltd., a stockholder of theCompany, to jointly design and develop, manufacture and sell telecommunicationproducts. The Company has a 49% ownership interest in the joint venturecompany, which has a registered share capital of $10.0 million. The cashconsideration of $4.9 million payable by the Company was paid inOctober 2002. As the Company does not have voting control over significantmatters of the joint venture company, the investment in and results ofoperations of the joint venture company are accounted for using the equitymethod of accounting. The Company recorded equity losses of $1.0 million and$1.0 million for the three months ended March 31, 2004 and 2003,respectively.  The equity loss for thequarter ended March 31, 2004 is recorded as a liability.

 

*Other investments*

 

The Company has also invested directly in a number of privatetechnology-based companies in the early stages of development. Theseinvestments are accounted for on the cost basis. The Company continuallyevaluates the carrying value of these investments for possible impairment basedon the achievement of business objectives and milestones, the financialcondition and prospects of these companies and other relevant factors. Duringthe three months ended March 31, 2004 and 2003, there were insignificantvaluation adjustments in respect of these private technology investments.

 

**15.****                               GOODWILLAND INTANGIBLE ASSETS:**

 

As of March 31, 2004 and December 31, 2003, goodwill andother acquired intangible assets consisted of the following (in thousands):

 

13

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| **(in thousands)**            |   | **March 31,  2004** |       | **December 31,  2003** |       |
|-------------------------------|--------|--------------------------|------------|-----------------------------|------------|
|                          |   |                     | ** ** |                        | ** ** |
| Goodwill                      |   | $                        | 113,003    |                        | $          | 113,003 |   |
| Less accumulated amortization |   | (12,823                  | )          | (12,823                     | )          |
|                          |   | $                        | 100,180    |                        | $          | 100,180 |   |
|                          |   |                     |       |                        |       |
| Identified intangible assets  |   |                     |       |                        |       |
|                          |   |                     |       |                        |       |
| Existing technology           |   | $                        | 26,096     |                        | $          | 25,968 |   |
| Less accumulated amortization |   | (9,593                   | )          | (7,891                      | )          |
|                          |   | $                        | 16,503     |                        | $          | 18,077 |   |
|                          |   |                     |       |                        |       |
| Customer relationships        |   | $                        | 27,820     |                        | $          | 27,820 |   |
| Less accumulated amortization |   | (2,318                   | )          | (1,623                      | )          |
|                          |   | $                        | 25,502     |                        | $          | 26,197 |   |
|                          |   |                     |       |                        |       |
| Trade names                   |   | $                        | 940        |                        | $          | 940 |   |
| Less accumulated amortization |   | (392                     | )          | (274                        | )          |
|                          |   | $                        | 548        |                        | $          | 666 |   |
|                          |   |                     |       |                        |       |
| Backlog                       |   | $                        | 1,950      |                        | $          | 1,950 |   |
| Less accumulated amortization |   | (1,625                   | )          | (1,137                      | )          |
|                          |   | $                        | 325        |                        | $          | 813 |   |
|                          |   |                     |       |                        |       |
| Total intangible assets       |   | $                        | 42,878     |                        | $          | 45,753 |   |

 

Amortization expense was $3.0 million and $0.7 million forthe three months ended March 31, 2004 and 2003, respectively. Theestimated aggregate amortization expense for intangibles for each of the fiveyears beginning the year ended December 31, 2005 through 2009 is$7.7 million, $5.9 million, $5.6 million, $4.0 million and$2.8 million, respectively.

 

Goodwill remained the same and intangible assets increased by $0.1million during the three months ended March 31, 2004. This increase wasattributable to $0.1 million of purchased technology. The estimated usefullife of purchased technology is from one to five years, the estimated usefullife of customer relationships is ten years, and the estimated useful lives ofbacklog and trade names are from one to two years.

 

**16.****                               SEGMENTREPORTING:**

 

The Company sells wireless, wireline and switching platforms tooperators in both fast growth and established telecommunications markets aroundthe world. The Company primarily operates in two geographic areas, China andother regions. The chief operating decision makers evaluate performance, makeoperating decisions, and allocate resources based on consolidated financialdata. Gross profit, operating income, income from operations, and income taxesare not allocated to specific individual departments within the organization.In accordance with SFAS No. 131 “Disclosures about Segments of anEnterprise and Related Information,” the Company is considered a singlereportable segment. The Company is required to disclose certain informationabout product revenues, information about geographic areas, information aboutmajor customers, and information about long-lived assets.

 

China sales accounted for 92% and 81% of net sales for the three monthsended March 31, 2004 and 2003, respectively. The Company groups all of itsChina customers together by province and treats each province as one customersince that is the level at which purchasing decisions are made. AtMarch 31, 2004 and 2003, there were approximately 31 such customers.Giving effect to this consolidation, for the three months ended March 31,2004, the Guangdong province accounted for 24% of net sales. For the threemonths ended March 31 2003, sales to the Hei Long Jiang province accountedfor 14%.

 

Geographical area and product sales data are as follows (in thousands):

 

14

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|                       |   | **Three  months ended March 31,** |        |
|----------------------------|--------|----------------------------------------|-------------|
|                       |   | **2004**                               |        |   |   | **2003** |   |   |   |
| **Sales by region**        |   |                                   |        |   |   |   |   |   |   |
| China                      |   | $                                      | 570,566     |   | 92 | % | $ | 268,929 |   | 81 | % |
| Japan                      |   | 19,427                                 |        | 3 | % | 59,821 |   | 18 | % |
| Other                      |   | 32,299                                 |        | 5 | % | 1,770 |   | 1 | % |
| **TOTAL NET SALES**        |   | **$**                                  | **622,292** |   | 100 | % | **$** | **330,520** |   | 100 | % |
|                       |   |                                   |        |   |   |   |   |   |   |
| **Sales by product  line** |   |                                   |        |   |   |   |   |   |   |
| Wireless infrastructure    |   | $                                      | 336,517     |   | 54 | % | $ | 66,201 |   | 20 | % |
| Subscriber handsets        |   | 236,420                                |        | 38 | % | 139,959 |   | 42 | % |
| Wireline products          |   | 49,355                                 |        | 8 | % | 124,360 |   | 38 | % |
| **TOTAL NET SALES**        |   | **$**                                  | **622,292** |   | 100 | % | **$** | **330,520** |   | 100 | % |

 

Long-lived assets by geography, consisting of property, plant andequipment, goodwill and intangible assets, are as follows (in thousands):

 
|                    |   | **March 31,  2004** |    | **December 31,  2003** |   |
|-------------------------|--------|--------------------------|---------|-----------------------------|--------|
| U.S.                    |   | $                        | 150,149 |                        | $      | 156,942 |   |
| Foreign                 |   | 193,671                  |    | 175,067                     |   |
| Total long-lived assets |   | $                        | 343,820 |                        | $      | 332,009 |   |

 

**17.****                               COMMITMENTSAND CONTINGENCIES:**

 

*JointVenture Funding:*

 

Pursuantto the joint venture agreement with Matsushita, the Company is jointly liablefor the losses incurred in the operations of the joint venture up to themaximum of its investment in the entity. At March 31, 2004, the losses had exceeded this amount; however, theCompany had accrued additional losses of approximately $1.0 million due to itscommitment to fund an additional investment of $9.3 million during the secondquarter of 2004.

 

*Investment Commitments:*

 

As of March 31, 2004, the Company had invested a total of$2.0 million in Global Asia Partners L.P. The fund size is anticipated tobe $10.1 million and the fund was formed to make private equityinvestments in private or pre-IPO technology and telecommunications companiesin Asia. The Company has a commitment to invest up to a maximum of$5.0 million. The remaining amount is due at such times and in suchamounts as shall be specified in one or more future capital calls to be issuedby the general partner.

 

*Purchase Commitments:*

 

The Company is obligated to purchase raw materials and work-in-processinventory under various orders from one supplier, all of which should be fulfilledwithout adverse consequences material to the operations or financial conditionof the Company. As of March 31, 2004, total open commitments under thesepurchase orders are approximately $1.0 million.

 

*Litigation:*

 

On October 31, 2001, a complaint was filed in United StatesDistrict Court for the Southern District of New York against the Company, someof its directors and officers and various underwriters for its initial publicoffering. Substantially similar actions were filed concerning the initialpublic offerings for more than 300 different issuers, and the cases werecoordinated as In re Initial Public Offering Securities Litigation, 21 MC 92.In April 2002, a consolidated amended complaint was filed in the matteragainst the Company, captioned In re UTStarcom, Initial Public OfferingSecurities Litigation, Civil Action No. 01-CV-9604. Plaintiffs allegeviolations of the Securities Act of 1933 and the Securities Exchange Act of1934 through undisclosed improper underwriting practices concerning theallocation of IPO shares in exchange for excessive brokerage commissions,agreements to purchase shares at higher prices in the aftermarket, andmisleading analyst reports. Plaintiffs seek unspecified damages on behalf of apurported class of purchasers of the Company’s common stock betweenMarch 2, 2000 and December 6, 2000. The Company’s directors andofficers have been dismissed without prejudice pursuant to a stipulation. OnFebruary 19, 2003, the Court granted in part and denied in part amotion to dismiss brought by defendants including the Company. The orderdismisses all claims against the Company except for a claim brought underSection 11 of the Securities

 

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Act of 1933, which alleges that the Company’s initial public offeringregistration statement contained untrue statements of material fact and omittedto state material facts required to be stated in the registration statement, ornecessary to make the statements therein not misleading. A proposal has beenmade for the settlement and release of claims against the issuer defendants,including UTStarcom. The settlement is subject to a number of conditions,including approval of the proposed settling parties and the court. If thesettlement does not occur, and litigation against UTStarcom continues,UTStarcom believes it has valid defenses and intends to defend the casevigorously. The Company is unable to currently estimate the loss, if any,associated with the above litigation.

 

The Company is a party to other litigation matters and claims that arenormal in the course of operations, and while the results of such litigationmatters and claims cannot be predicted with certainty, the Company believesthat the final outcome of such matters will not have a material adverse impacton its financial position or results of operations.

 

**18.****                               RELATEDPARTY TRANSACTIONS:**

 

The Company recognized revenue of $11.6 million and $58.5 millionfor the three months ended March 31, 2004 and 2003, respectively, with respectto sales of telecommunications equipment to SBBC, an affiliate of SOFTBANKAmerica Inc., which is a significant stockholder of the Company. SBBCoffers asynchronous digital subscriber line (“ADSL”) coverage throughout Japan,which is marketed under the name “YAHOO BB!”. The Company provides ADSLtechnology to SBBC. The contract was competitively bid and the terms of thiscontract were on terms no more favorable than those with unrelated parties.Included in accounts receivable at March 31, 2004 and December 31,2003 were $29.8 million and $43.9 million, respectively, related to thisagreement. There were no amounts included in deferred revenue in respect ofthis agreement at March 31, 2004 and December 31, 2003.

 

The Company has invested in Softbank China and Restructuring FundNo. 1, which are investment vehicles established by SOFTBANK CORP. and itsaffiliates. See Note 14.

 

On April 5, 2003, the Company repurchased 8.0 million sharesof common stock beneficially owned by SOFTBANK America Inc., at a purchaseprice of $17.385 per share. The total cost of the repurchase was$139.6 million including transaction fees. In connection with thisrepurchase transaction, SOFTBANK America Inc. entered into an agreementwith the Company not to offer, sell or otherwise dispose of the Company’scommon stock for a period of one year, subject to a number of exceptions. As ofMarch 31, 2004, SOFTBANK America Inc. beneficially ownedapproximately 12.8% of the Company’s outstanding stock.

 

**19.****                               COUNTRYRISKS:**

 

Approximately 92% and 81% of the Company’s net sales for the threemonths ended March 31, 2004 and 2003, respectively, were made in China.Accordingly, the Company’s business, financial condition and results ofoperations are likely to be influenced by the political, economic and legalenvironment in China and by the general state of China’s economy. As such, theCompany’s operations in China are subject to special considerations andsignificant risks not typically associated with companies in the United States.The Company’s results may be adversely affected by, among other things, changesin the political, economic, competitive and social conditions in China,including changes in governmental policies with respect to laws andregulations, changes in China’s telecommunications industry and regulatoryrules and policies, anti-inflationary measures, currency conversion andremittance abroad, and rates and methods of taxation.

 

Under China’s current regulatory structure, the communications productsthat the Company offers in China must meet government and industry standards,and a network access license for the equipment must be obtained. Without thelicense, the equipment may not be connected to public telecommunicationsnetworks or sold in China. Moreover, the Company must ensure that the qualityof the telecommunications equipment for which it has obtained a network accesslicense is stable and reliable, and may not lower the quality or performance ofother installed licensed products. China’s State Council’s product qualitysupervision department, 

 

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in concert with China’s Ministry of Information Industry, performs spotchecks to track and supervise the quality of licensed telecommunicationsequipment and publishes the results of such spot checks.

 

Approximately 3%and 18% of the Company’s sales for the three months ended March 31, 2004and 2003, respectively, were made in Japan. Accordingly, the political,economic and legal environment and the general state of Japan’s economy mayinfluence the Company’s business, financial condition and results ofoperations.

 

**20.****                               INCOMETAX ASSETS AND LIABILITIES:**

 

In establishing its deferred income tax assets and liabilities, theCompany makes judgments and interpretations based on the enacted tax laws andpublished tax guidance applicable to its operations.  The Company recordsdeferred tax assets and liabilities and evaluates the need for valuationallowances to reduce the deferred tax assets to realizable amounts.  The likelihoodof a material change in the Company’s expected realization of these assets isdependent on future taxable income, its ability to use foreign tax creditcarryforwards and carrybacks, and the effectiveness of its tax planningstrategies in the various relevant jurisdictions.  Changes to theCompany’s income tax provision or in the valuation of the deferred tax assetsand liabilities may affect its annual effective income tax rate.

 

**21.          ACCOUNTINGFOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES:**

 

The Company uses derivative financial instruments to manage itsexposures to foreign currency exchange rate changes. The derivative instrumentsare accounted for pursuant to SFAS No. 133, “Accounting for DerivativeInstruments and Hedging Activities”, as amended by SFAS No. 138, “Accountingfor Certain Derivative Instruments and Certain Hedging Activities”. As amended,SFAS No. 133 requires that an entity recognize all derivatives as either assetsor liabilities on the balance sheet, measure those instruments at fair valueand recognize changes in the fair value of derivatives in earnings in theperiod of change unless the derivative qualifies as an effective hedge thatoffsets certain exposures. Such contracts are designated at inception to therelated foreign currency exposures being hedged. Beginning in the first quarterof 2004, the Company hedges certain of its Japanese Yen-denominated balancesheet exposures against future movements in foreign currency exchange rates byusing foreign currency forward contracts. Hedged transactions are denominatedin U.S. dollars on behalf of these transactions denominated in Japanese Yen.Pursuant to its foreign currency exchange hedging policy, the Company may hedgeanticipated transactions and the related payables denominated in foreigncurrencies using forward foreign currency exchange rate contracts.  Gains and losses on these fair value hedgesare intended to offset gains and losses from the revaluation of JapaneseYen-denominated recognized liabilities. The net result of these gains andlosses on contracts and revaluation included in interest and other income(expense) was insignificant for the three months ended March 31, 2004. TheCompany’s foreign currency forward contracts generally mature within threemonths. These derivative financial instruments are not held for tradingpurposes. There were no foreign currency forward contracts held at March 31,2004.

 

**22.****                               RECENTACCOUNTING PRONOUNCEMENTS:**

 

In November 2003,the EITF issued EITF No. 03-6 “ Participating Securities and the Two-ClassMethod under FASB Statement No. 128,” which provides for a two-class method ofcalculating earnings per share computations that relate to certain securitiesthat would be considered to be participating in conjunction with certain commonstock rights. This guidance would be applicable to the Company starting withthe second quarter beginning April 1, 2004. The Company is currentlyevaluating the potential impact of this pronouncement on its financialstatements.

 

**23.****                               SUBSEQUENTEVENTS:**

 

On April 21, 2004, the Company entered into an agreement topurchase substantially all of the assets and assume certain liabilities ofTELOS Technology, Inc. (“TELOS”) and its subsidiaries.  The transaction includes an initial cashconsideration of $29.0 million, with an additional payment of up to $19.0million based upon recognized revenue from the sale of TELOS products. TELOS isa provider of mobile switching products and services for voice and datacommunication networks. Closing of the transaction is subject to satisfactionor waiver of certain conditions outlined in the purchase agreement. Thetransaction has been approved by the boards of directors of both companies andby the stockholders of TELOS.  Approvalof the Company’s stockholders is not required.

 

On April 27, 2004, the Company completed the purchase of theassets, certain employees and certain contracts related to Hyundai SyscommInc.’s (“HSI”) CDMA infrastructure business for markets outside of Korea. Inaddition, the Company bought substantially all of HSI’s registered intellectualproperty, which has been licensed back to HSI for its business in Korea.  Subject to the attainment of certainmilestones and the transfer of certain know-how, the total consideration forthis transaction is approximately $14.3 million.  There was $7.3 million in cash payable at the closing date and anadditional $3.0 million in cash payable one year from the closing date.  In conjunction with this transaction, theCompany loaned HSI $3.2 million at an effective interest rate of 12% per annum,which was used by HSI to satisfy outstanding debt obligations. The principalamount of the loan is due in April 2005. The Company may set-off HSI’s payment obligations against the outstanding$3.0 million of the purchase price.  Theremaining $4.0 million of the purchase price is comprised of $2.0 millionpayable upon the transfer of manufacturing know-how from HSI to oursubsidiaries in China and $2.0 million payable upon the completion of certainrevenue milestones.

 

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**ITEM 2****—MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS**

 

**FORWARD-LOOKING STATEMENTS**

 

This Report on Form 10-Q contains forward-looking statementswithin the meaning of the federal securities laws. These statements are basedon information that is currently available to management. We intend suchforward-looking statements to be covered by the safe harbor provisions of thePrivate Securities Litigation Reform Act of 1995, and we are including thisstatement for purposes of complying with those provisions. The forward-lookingstatements include, without limitation, those concerning the following: ourexpectations as to the nature of possible trends, including our expectationsabout continuing growth in the number of subscribers for telecommunicationsproducts in China; our expectations regarding continued growth in our businessand operations; our expectation that there will be fluctuations in our overallgross profit, gross margin, product mix, quarter to quarter results, customerbase and selling prices; our plans for expanding the direct sales organizationand our selling and marketing campaigns and activities; our expectation that wemay use our cash, debt or securities to acquire or invest in complementarybusinesses, technologies or product offerings; our expectation that there willbe increases in selling, marketing, research and development, and general andadministrative expenses; our expectations regarding future growth of our businessand operations; our expectation that we will continue to invest significantlyin research and development; our expectations regarding the status of productsunder development; our expectations regarding our future investments; ourexpectations regarding our future levels of cash and cash equivalents, as wellas our expectation that existing cash and cash equivalents will be sufficientto finance our operations for the foreseeable future; our expectationsregarding licensing requirements and our ability to receive licenses in Chinafor our PAS system and other products; our expectations regarding thedevelopment of a 3G network in China; our expectations regarding the impact ofa reorganization of China Netcom; our expectation that our business will continueto be significantly influenced by the political, economic and legal environmentin China, as well as expectations about the nature of political, economic andlegal reform in China; our expectations regarding the future allocation of netsales by product group; our expectations regarding efficiencies we hope toachieve in supply chain and inventory purchasing, as well as trends ininventory growth; and our expectations regarding our expansion into new marketsaround the world. Additional forward-looking statements may be identified bythe words, “anticipate,” “expect,” “believe,” “intend,” “will” and similarexpressions, as they relate to us or our management. Investors are cautionedthat these forward-looking statements are inherently uncertain. These statementsare subject to risks and uncertainties that may cause actual results and eventsto differ materially. For a detailed discussion of these risks anduncertainties, see the “Factors Affecting Future Operating Results”section of this Form 10-Q. We do not guarantee future results andundertake no obligation to update the forward-looking statements to reflectevents or circumstances occurring after the date of this Form 10-Q.

 

## **EXECUTIVE SUMMARY**

## ** **

We design, manufacture and sell telecommunications equipment andproducts and provide services associated with their operation. Our products aredeployed and installed exclusively by telecommunications wireless and wirelineservice providers. We provide an extensive range of products for transportationof voice, data and video traffic for service providers around the world. Ourbusiness is conducted globally in China, Japan, India, the Central and LatinAmerican region, North America, the European, Middle Eastern and African regionand southeastern and northern Asia. Our objective is to be a leading globalprovider of Internet Protocol (“IP”) networking products and services. Wedifferentiate ourselves with products designed, developed and commercialized toreduce network complexity, integrate high performance capabilities and thatallow a simple transition to next generation networks. This results indeployment, maintenance and upgrades that are both economical and efficient,allowing operators to earn a high return on their investment.

 

Our technologies and products fall into three major categories:

 

•                                          wireless,a technology that enables end users, or subscribers, to send and receive voiceand data while mobile and using wireless devices;

 

•                                          wireline,a technology that satisfies customer demand for high-speed, cost effectivedata, voice and media transport and carriage; and

 

•                                          switching,a diverse assembly of software and hardware based networking elements designedto replace central office telephone switches.

 

Our products within each of these categories include multiple hardwareand software subsystems that can be offered in various combinations to suitindividual subscriber needs. Our system technologies and products are based onwidely adopted global communications standards and are designed to allowservice providers to quickly and cost-efficiently integrate our systems intotheir existing networks and deploy our systems in new broadband, InternetProtocol (“IP”) and wireless network rollouts. Our system 

 

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technologies are also designed to allow timely and cost efficienttransition to future next-generation network technologies, enabling our serviceprovider customers to protect their initial infrastructure investments.

 

Historically, substantially all of our sales have been to serviceproviders in China. 92% of our sales for the three months ended March 31,2004 were derived from China. However, we are currently expanding our salesefforts to include other communications markets such as in the Central andLatin American region, the European, Middle Eastern and African region, NorthAmerica and southeastern and northern Asia. We intend to penetrate thesemarkets through direct sales offices located in key market regions, bylicensing our technology to local manufacturers where import taxation isfavorable, by developing local sales agency and distributor relationshipswithin specific market regions, and by establishing sales relationships withoriginal equipment manufacturers. Our sales division began establishing regionaloffices and local direct sales representative offices to provide support forour expanding global sales operations.

 

In a telecommunications industry that has experienced a period ofcontraction over the last few years, we have experienced significant growth inrevenue. For the three months ended March 31, 2004, we had $622.3 millionof revenue, an 88% increase over the corresponding period in 2003. This growthin revenue was driven by China’s growing telecommunications market. China,which we believe to be one of the fastest growing telecommunications markets inthe world, continued to experience increasing fixed-line and mobile telephoneand Internet subscriber growth, from 480.1 million subscribers in 2002 to611.5 million subscribers in 2003, according to China’s Ministry ofInformation Industry. We believe this subscriber growth led to increased demandfor our PAS services and handsets during the first quarter of fiscal year 2004.We use subscriber growth statistics to gauge future inventory purchasingrequirements as well as to forecast our anticipated revenue growth. We expectthis subscriber growth trend to continue throughout 2004 as China’s teledensityrates remain low in comparison to that of developed countries.

 

The number of competitors for communications access and switchingsystems and handsets in China has grown in line with China’s growingtelecommunications market. This growth has led to competitive pricing pressure,causing our average selling prices to decrease during the three months endedMarch 31, 2004 relative to those in the comparative period in 2003. Thispricing pressure affected both our infrastructure and handset product lines,contributing to decreased margins overall. We strive to develop products with more advanced features and to enhancethe features of our existing products, which we believe will enable us to offerour customers a more advanced product at a higher average selling price thanotherwise would be possible when the products are ready for sale. In addition,during the first quarter of 2004, we continued to strive to reduce the cost ofmanufacturing our products by streamlining our design functions.

 

Historically and in the current period, slower business activityattributable to typical winter seasonality and the Chinese New Year affectedour operating results for the first quarter of the fiscal year.  Cash used in operations was $27.3 millionfor the three months ended March 31, 2004.  This compares favorably to the $74.8 million of operating cashconsumed in the first quarter of 2003, and we expect positive cash flows fromoperations for the full fiscal year 2004. In an effort to penetrate new marketsaround the world, support our growing business and expand our productofferings, we continued to invest resources in our selling, administrative andresearch and development groups. While these operating costs have increasedsignificantly in line with increasing sales, we have decreased operating costsas a percentage of revenues to 19% for the three months ended March 31,2004 from 20% for the three months ended March 31, 2003.

 

# ***KEYTRANSACTIONS***

#  

### ***Stockholders’ Equity***

### * *

On January 14, 2004, we sold 12.1 million shares of commonstock at $39.25 per share in a privately negotiated transaction with aninstitution, for net proceeds of approximately $474.6 million. The netproceeds are intended to fund strategic and general corporate activities,including, but not limited to, acquisitions, investments or capitalexpenditures.

 

On March 12, 2004, we announced a stock repurchase program,authorizing the repurchase of up to 5,000,000 shares of our outstanding stockover a period of 6 months. The Board approved an additional repurchase of1,623,000 shares in a privately negotiated transaction with an institution.  We repurchased a total of approximately 2.6million shares at an average price of $30.43 per share, for a total cashoutflow of $78.2 million. The authorized repurchase period will expire in thethird quarter of this fiscal year.

 

# ***Transactionswith Softbank and AffiliatedEntities***

#  

We recognized revenue of $11.6 million and $58.5 million for thethree months ended March 31, 2004 and 2003, respectively, with respect tosales of telecommunications equipment to Softbank BB Corporation (“SBBC”), anaffiliate of SOFTBANK CORP. and SOFTBANK America Inc., a significantstockholder of ours. SBBC offers asynchronous digital subscriber line (“ADSL”)coverage throughout Japan, which is marketed under the name “YAHOO BB!”. Themajority of the products we provide to SBBC is associated with ADSL technology.The contract was competitively bid and the terms of this contract were on termsno more favorable than those

 

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with unrelated parties. Included in accounts receivable at March 31,2004 and December 31, 2003 were $29.8 million and $43.9 million,respectively, related to this agreement. There were no amounts included indeferred revenue in respect to this agreement at March 31, 2004 andDecember 31, 2003.

 

During 2000, we invested $10.0 million in Softbank China, aninvestment fund established by SOFTBANK CORP. focused on investments inInternet companies in China. This investment permits us to participate in theanticipated growth of Internet-related businesses in China. Our investmentconstitutes 10% of the funding for Softbank China, with SOFTBANK CORP.contributing the remaining 90%. The fund has a separate management team, andnone of our employees are employed by the fund. Many of the fund’s investmentsare and will be in privately held companies, many of which are still in thestart-up or development stages. These investments are inherently risky as themarket for the technologies or products the companies have under developmentare typically in the early stages and may never materialize. We account forthis investment under the cost method and recorded insignificant losses andlosses of $0.1 million due to an other-than-temporary decline in thecarrying value of this investment for both the three months ended March 31,2004 and 2003. The balance in this investment was $5.3 million atMarch 31, 2004.

 

During the first quarter of fiscal 2002, we invested $2.0 millionin Restructuring Fund No. 1, a venture capital investment limitedpartnership established by SOFTBANK INVESTMENT CORP., an affiliate of SOFTBANKCORP. The fund focuses on leveraged buyout investments in companies in Asiaundergoing restructuring or bankruptcy proceedings. The total fund offering isexpected to be between approximately $150.0 million and $226.0 million,with each investor contributing a minimum of $0.8 million. The fund has aseparate management team, and none of our employees are employed by the fund.We account for this investment under the equity method of accounting. Duringthe three months ended March 31, 2004, we recorded insignificant equitylosses and recorded no losses for the corresponding period in 2003. The balancein this investment was $1.8 million at March 31, 2004.

 

On April 5, 2003, we repurchased 8.0 million shares of ourcommon stock beneficially owned by SOFTBANK America Inc., at a purchaseprice of $17.385 per share. The total cost of the repurchase was$139.6 million including transaction fees. In connection with thisrepurchase transaction, SOFTBANK America Inc. entered into an agreementwith us not to offer, sell or otherwise dispose of our common stock for aperiod of one year, subject to a number of exceptions. As of March 31,2004, SOFTBANK America Inc. beneficially owned approximately 12.8 % of ouroutstanding stock.

 

***Subsequent Events***

*** ***

On April 21, 2004, we entered into an agreement to purchasesubstantially all of the assets and assume certain liabilities of TELOSTechnology, Inc. (“TELOS”) and its subsidiaries.  The transaction includes an initial cash consideration of $29.0million, with an additional payment of up to $19.0 million based uponrecognized revenue from the sale of TELOS products. TELOS is a provider ofmobile switching products and services for voice and data communicationnetworks. Closing of the transaction is subject to satisfaction or waiver ofcertain conditions outlined in the purchase agreement. The transaction has beenapproved by the boards of directors of both companies and by the stockholdersof TELOS.  Approval of our stockholdersis not required.

 

On April 27, 2004, we completed the purchase of the assets,certain employees and certain contracts related to Hyundai Syscomm Inc.’s(“HSI”) CDMA infrastructure business for markets outside of Korea. In addition,we bought substantially all of HSI’s registered intellectual property, whichhas been licensed back to HSI for its business in Korea.  Subject to the attainment of certainmilestones and the transfer of certain know-how, the total consideration forthis transaction is approximately $14.3 million.  There was $7.3 million in cash payable at the closing date and anadditional $3.0 million in cash payable one year from the closing date.  In conjunction with this transaction, weloaned HSI $3.2 million at an effective interest rate of 12% per annum, which wasused by HSI to satisfy outstanding debt obligations. The principal amount ofthe loan is due in April 2005.  Wemay set-off HSI’s payment obligations against the outstanding $3.0 million ofthe purchase price.  The remaining $4.0million of the purchase price is comprised of $2.0 million payable upon thetransfer of manufacturing know-how from HSI to our subsidiaries in China and$2.0 million payable upon the completion of certain revenue milestones.

 

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**RESULTS OF OPERATIONS**

 

Approximately 92% and 81% of our net salesfor the three months ended March 31, 2004 and 2003, respectively, were inChina. Accordingly, our business, financial condition and results of operationsare likely to be influenced by the political, economic and legal environment inChina, and by the general state of China’s economy for the foreseeable future.Our results may be adversely affected by, among other things, changes in thepolitical, economic, competitive and social conditions in China, includingchanges in governmental policies with respect to laws and regulations, changesin the telecommunications industry and regulatory rules and policies,anti-inflationary measures, currency conversion and remittance abroad, andrates and methods of taxation. We extend credit to our customers in Chinawithout requiring collateral. We monitor our exposure for credit losses andmaintain allowances for doubtful accounts. Business activity in China and manyother countries in Asia declines considerably during the first quarter of eachyear in observance of the Lunar New Year. As a result, we have lower salesactivity during the first quarter of our fiscal year relative to historical andexpected year-long trends, and we expect this trend to continue.

 

Cost of sales consists primarily of material costs, payments to agents,costs associated with manufacturing, assembly and testing of products, costsassociated with installation and customer training and overhead and warrantycosts. Cost of sales also includes import taxes and tariffs on components andassemblies. Some components and materials used in our products are purchasedfrom a single supplier or a limited group of suppliers and, in some cases, aresubject to our obtaining Chinese import permits and approvals. We also rely onthird party manufacturers in China to manufacture and assemble most of ourhandsets. Our cost of sales was also impacted by the fact that a significantportion of our inventory component purchases was denominated in Japanese Yen.Although the dollar strengthened against the Yen in the current period, thecost of inventory included in our cost of sales is based on exchange rates fromapproximately four to six months ago due to our using the exchange rates on thedate the inventory was received to calculate inventory cost.

 

Our gross profit has been affected by productmix, average selling prices and material costs. Our gross profit, as apercentage of net sales, varies among our product families. We expect that ouroverall gross profit, as a percentage of net sales, will fluctuate from periodto period as a result of shifts in product mix, anticipated decreases inaverage selling prices and our ability to reduce cost of sales.

 

Selling, general and administrative expensesinclude compensation and benefits, professional fees, sales commissions,provision for doubtful accounts receivable and travel and entertainment costs.A large percentage of our costs are fixed and are difficult to quickly reducein periods of reduced sales. We intend to pursue aggressive selling andmarketing campaigns and to expand our direct sales organization, and, as aresult, our sales and marketing expenses will increase in absolute dollars infuture periods. We also expect that in support of our continued growth, generaland administrative expenses will continue to increase in absolute dollars forthe foreseeable future.

 

Research and development expenses consistprimarily of salaries and related costs of employees engaged in research,design and development activities, the cost of parts for prototypes, equipmentdepreciation and third party development expenses. A large percentage of ourcosts is fixed and difficult to quickly reduce in periods of reduced sales. Ourresearch and development efforts are focused on developing both future,next-generation products as well as working to upgrade our existing systems andproducts. We believe that continuedinvestment in research and development is critical to our long-term success.Accordingly, we expect that our research and development expenses will increasein absolute dollars in future periods.

 

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**THREE MONTHS ENDEDMARCH 31, 2004 AND MARCH 31, 2003**

 

**NET SALES**

 
|                    |   | **Three  months ended March 31,** |    |
|-------------------------|--------|-----------------------------------|---------|
| **Sales by region**     |   | **2004**                          |    |   |   | **2003** |   |   |   |
|                    |   | **(in  thousands)**               |    |
| China                   |   | $                                 | 570,566 |   | 92% |   | $ | 268,929 |   | 81% |   |
| Japan                   |   | 19,427                            |    | 3% |   | 59,821 |   | 18% |   |
| Other                   |   | 32,299                            |    | 5% |   | 1,770 |   | 1% |   |
| **TOTAL NET SALES**     |   | $                                 | 622,292 |   | 100% |   | $ | 330,520 |   | 100% |   |
|                    |   |                              |    |   |   |   |   |   |   |
| Sales by product line   |   |                              |    |   |   |   |   |   |   |
| Wireless infrastructure |   | $                                 | 336,517 |   | 54% |   | $ | 66,201 |   | 20% |   |
| Subscriber handsets     |   | 236,420                           |    | 38% |   | 139,959 |   | 42% |   |
| Wireline products       |   | 49,355                            |    | 8% |   | 124,360 |   | 38% |   |
| **TOTAL NET SALES**     |   | $                                 | 622,292 |   | 100% |   | $ | 330,520 |   | 100% |   |

 

This increase in sales was primarily attributable to increased demandfor our products and services and the continued strength of our sales in Chinaand globally. Net sales growth was primarily due to an increase in subscribers,requiring telecommunication providers to expand their telecommunication infrastructures.This changed our sales mix, and a greater percentage of wireless infrastructureproducts were sold during the three months ended March 31, 2004 than in thecomparative period in 2003.

 

Thedecrease in wireline sales is attributable to several factors. Primarily, thisdecrease is due to China’s evolution from wireline to wireless technology. AsChina evolves into using wireless technology for its telecommunications needs,our sales of wireline products have decreased. Additionally, sales of wirelineproducts were atypically high for the three months ended March 31, 2003 due toJapan’s expansion of its wireline infrastructure base in that period. 100% ofsales to Japan were wireline product sales for the three months ended March 31,2003 as compared to approximately 60% for the three months ended March 31,2004. .

 

Inaddition to increasing the amount of infrastructure sales, this increase insubscribers also led to an increase in customer demand for handsets in thefirst quarter 2004 as compared to the first quarter 2003, contributing to theincrease in absolute dollars of handset sales.

 

We group all of our China customers togetherby province and treat each province as one customer since that is the level atwhich purchasing decisions are made. At March 31, 2004 and 2003, we had 31 suchcustomers. The Guangdong province accounted for 24% of our net sales for thethree months ended March 31, 2004. The Hei Long Jiang province accounted for14% of our net sales for the three months ended March 31, 2003. We expect oursales to grow at a moderate rate through 2004, with our global sales growing ata higher rate than our China sales. Our handset sales increased as a result ofincreased total PAS subscribers, from approximately 17.1 million subscribersat March 31, 2003 to approximately 46.9 million subscribers at March 31,2004, and we expect this growth rate to continue throughout the remainder of2004.

 

We expect that 2004 net sales will be comprised of approximately 45% to55% wireless infrastructure sales, approximately 35% to 45% subscriber handsetsales and approximately 10% to 20% wireline products.

 

**GROSS PROFIT**

 
|                    |   | **Three  months ended March 31,** |   |
|-------------------------|--------|-----------------------------------|--------|
|                    |   | **2004**                          |   | **2003** |   |
|                    |   | **(in  thousands)**               |   |
|                    |   |                              |   |   |   |
| Gross profit            |   | $176,034                          |   | $112,685 |   |
| Gross profit percentage |   | 28                                | %      | 34 | % |
|                         |        |                                   |        |  |  |  |

 

Our gross profit varies across our different product lines and isaffected by product mix, average selling prices and the cost of materials. Thedecrease in gross profit as a percent of net sales for the three months endedMarch 31, 2004 from the corresponding period in 2003 was primarily attributableto decreased sales of our higher margin wireline products.  Our gross profit also decreased during thethree months ended March 31, 2004 due to higher cost of sales from inventorycomponent purchases denominated in Japanese Yen as a result of the appreciationof the Yen versus the dollar during the months in which this inventory wasreceived.  Finally, the decline in grossprofit resulted from increased competitive market pricing pressures on ourhandset products, a result of continued pricing pressures throughout thetelecommunications market in the first quarter of 2004.

 

We believe that our overall gross profit as a percentage of net saleswill continue to fluctuate from period to period as a result of shifts inproduct mix, anticipated decreases in average selling prices and our ability toreduce cost of sales. We expect that there

 

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will be continued competitive market pricing pressures on our productsin line with current trends in the industry. We expect that fluctuations in the value of Japanese Yen will continueto affect our cost of goods sold and our gross profit.

 

**OPERATING EXPENSES**

 

The following table summarizes our operating expenses:

 
|                                                         |   | **Three  months ended March 31,** |    |
|--------------------------------------------------------------|--------|-----------------------------------|---------|
|                                                         |   | **2004**                          |    | **%****of net  sales** |   | **2003** |   | **%****of net  sales** |   |
|                                                         |   | **(in  thousands)**               |    |
|                                                         |   |                              |    |   |   |   |   |   |   |
| Selling, general and administrative  (“SG&A”)  |   |                              |    |   |   |   |   |   |   |
| expenses                                                     |   | $                                 | 66,943  |   | 11% |   | $ | 37,583 |   | 11% |   |
| Research and development (“R&D”)               |   | 45,658                            |    | 7% |   | 26,812 |   | 8% |   |
| In-process research and development  (“IPR&D”) |   | —                            |    | 0% |   | 1,320 |   | 0% |   |
| Amortization of intangible assets                            |   | 2,973                             |    | 0% |   | 695 |   | 0% |   |
|                                                         |   |                              |    |   |   |   |   |   |   |
| **TOTAL OPERATING  EXPENSES**                                |   | $                                 | 115,574 |   | 19% |   | $ | 66,410 |   | 20% |   |

 

*Selling, general and administrative*

 

The increase in absolute dollars in selling, general and administrativeexpenses is due to the hiring of additional personnel to support our increasedbusiness activities both in China and globally.  Selling, general and administrative headcount increased to 2,679employees at March 31, 2004 as compared to 1,810 employees at March 31, 2003,causing the increase in absolute dollars. The new personnel will help support our expanding global businessoutside of China.

 

*Research and development*

 

The increase in absolute dollars of research and development expenseswas primarily due to hiring additional technical personnel to support ourincreased business levels. Research and development headcount increased to2,342 employees at March 31, 2004 as compared to 1,440 employees at March 31,2003.  The decrease of research anddevelopment expenses as a percentage of net sales was due to increasedeconomies of scale associated with increased business levels. The majority ofthe new personnel being hired in China, where labor costs are less expensivethan in the United States, also contributed to the decrease in research anddevelopment expenses as a percentage of net sales.

 

*In-process research and development costs*

 

There was no charge to IPR&D for the three months ended March 31,2004.  The $1.3 million charge for thethree months ended March 31, 2003 arose from our acquisition of Shanghai Yi Yunand was based on an independent valuation.

 

*Amortization of intangible assets*

 

The increase in the amortization of intangible assets for the threemonths ended March 31, 2004 is due to an additional $44.9 million ofintangibles recorded upon our acquisition of CommWorks in May 2003.  The estimated useful lives of thesepurchased intangibles are from one to ten years.  Estimated amortization expense for the next five years, beginningwith the year ended December 31, 2005 is $7.7 million, $5.9 million, $5.6million, $4.0 million and $2.8 million.

 

**OTHER INCOME (EXPENSES)**

 

*Interest income*

 

Interest income was $1.4 million and $0.9 million for the three monthsended March 31, 2004 and 2003, respectively. The increase in interest incomewas due to higher average cash balances for the three months ended March 31,2004 as compared to the corresponding period in 2003.

 

*Interest expense*

 

Interest expense was $1.1 million and $0.6 million for the three monthsended March 31, 2004 and 2003, respectively. The 

 

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increase in interest expense was primarily due to interest expense and amortizationof debt issuance costs relating to $402.5 million of convertible subordinatednotes that we issued in March 2003.

 

*Other income (expense), net*

 

Net other income was $8.8 million and $4.2 million for the three monthsended March 31, 2004 and 2003, respectively. Net other income for the threemonths ended March 31, 2004 was primarily due to our receiving a $7.8 millionfinancial subsidy from the local Chinese government.  This subsidy is to encourage our investment in local research anddevelopment and manufacturing activities. We also recorded a Japanese consumption tax refund of $1.4 million,offset by a $0.4 million foreign exchange loss.  Net other income for the three months ended March 31, 2003 wasprimarily due to a reinvestment incentive payment received in China of $3.9million.

 

### *Equity in net loss of affiliatedcompanies*

 

Equity in net loss of affiliated companies was $1.0 millionfor both of the three months ended March 31, 2004 and 2003, respectively andprimarily resulted from losses incurred at our joint venture with MatsushitaCommunication Industrial Co., Ltd., and Matsushita Electric IndustrialCo., Ltd.

 

### *Income tax expense*

 

Income tax expense was $13.7 million and $12.4 million for the threemonths ended March 31, 2004 and 2003, respectively. The primary reason for theincrease in income tax expense was that our income before taxes increased 38%for the three months ended March 31, 2004 from the corresponding period in2003. Despite the increase in income tax expense, the overall effective taxrate decreased to 20% for 2004 as compared with 25% in 2003.  This decrease is a result of continued taxholidays in China as well as a greater proportion of income in countries withlow tax rates.  We expect that ourincome tax expense will grow in absolute dollars in line with anticipatedincreases in pretax income.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

**Liquidity and CapitalResources**

 

*Operating Activities*

 

*2004*

 

Net cash used inoperating activities for the three months ended March 31, 2004 was $27.3million. Operating cash was affected by changes in accounts receivable,inventory and customer advances offset by changes in deferred costs andaccounts payable.  The lower level ofbusiness activity resulting from typical winter seasonality and from theChinese New Year impacted our operating cash for the first quarter of 2004,consistent with comparative periods in prior years. The $69.9 million increasein accounts receivable was, in part, attributable to lower cash collections dueto the Chinese New Year and the resulting decreased activity level. Inventoryincreased by $70.5 million, also decreasing our operating cash.  As we expect sales to increase in subsequentquarters, we built our inventory supply in this period to meet the anticipateddemand in future periods.  The $156.4million decrease in customer advances also decreased operating cash for theperiod.  Customer advances, whichrepresent cash deposits we have received from our customers for orders thathave not yet received final acceptance, decreased due to an increased amount ofcustomer acceptances.  Offsetting theactivity that decreased operating cash for the period were changes in deferredcosts and accounts payable. Deferred costs, or inventory at customer sitesawaiting final acceptance, decreased by $132.7 million.  The decrease in deferred costs was also aresult of increased revenues and a greater number of customer acceptances,corresponding to the decrease in customer advances.  Accounts payable increased by $36.8 million, due to increasedinventory purchasing.

 

*2003*

 

Net cash used in operations for the three months ended March 31, 2003of $74.8 million was primarily due to an increase in inventory, deferred costs,accounts receivable and other current and non-current assets of $131.1 million,$241.2 million, $41.4 million and $52.1 million, respectively.  This was partially offset by net income of$37.3 million, adjusted for non-cash charges including depreciation andamortization expense of $7.9 million and allowance for doubtful accounts of$8.2 million, as well as growth in accounts payable of $219.9 million, otheraccrued liabilities of $12.2 million, customer advances of $87.2 million,deferred revenue of $5.7 million and income taxes payable of $5.9 million.

 

*Investing Activities*

 

*2004*

 

Net cash used ininvesting activities for the three months ended March 31, 2004 of $28.0 millionwas primarily due to purchases

 

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of property, plant and equipment to support ourexpansion.  $12.4 million of the total$27.7 million in property, plant and equipment purchases were constructioncosts incurred on our Hangzhou manufacturing facility.  Additional investing activities include anadditional $1.0 million investment in Fiberxon, offset by net proceeds from thesale of short-term investments of $0.9 million.

 

*2003*

 

Net cash provided by investing activities for the three months endedMarch 31, 2003 of $53.6 million was primarily due to net sales of short-terminvestments of $75.6 million offset by purchases of property, plant andequipment of $15.2 million.

 

*Financing Activities*

 

*2004*

 

Net cash provided by financing activities was$405.6 million for the three months ended March 31, 2004.  This was primarily due to proceeds raisedfrom our selling 12.1 million shares of common stock at $39.25 per share toBanc of America Securities, LLC, for net proceeds of approximately $474.6million. In addition to the sale of stock, we received $9.2 million for theissuance of common stock through stock option exercises. Offsetting cashprovided by operating activities, we used a portion of the capital raised torepurchase a total of 2.6 million shares of our common stock at an averageprice of $30.43 per share for a total cost of $78.2 million, including transactionfees.

 

*2003*

 

Net cash provided by financing activities for the three months endedMarch 31, 2003 of $351.7 million was primarily due to the offering ofconvertible subordinated notes of $391.4 million and proceeds from the exerciseof stock options of $4.0 million, offset by purchases of call options for $43.8million.

 

*Liquidity*

 

Our working capital was $1.3 billion and$957.9 million at March 31, 2004 and 2003, respectively. This increase inworking capital is due to increased cash on hand, to $724.9 million incash and cash equivalents and $41.3 of short-term investments at March 31,2004, from $562.1 million of cash and cash equivalents and $42.0 millionof short-term investments at March 31, 2003. Our working capital also increaseddue to larger accounts receivable and inventory balances and lower customeradvances, offset by smaller deferred costs balances, and higher accountspayable and deferred revenue balances. Cash on hand increased due to $474.6million of net proceeds received from our equity offering in January 2004. Thiscash positions us to take advantage of strategic investment opportunities.

 

Our China sales are generally denominated inlocal currency. Due to the limitations on converting Renminbi, we are limitedin our ability to engage in foreign currency hedging activities in China. Salesoutside China are generally denominated in US dollars. We cannot guarantee thatfluctuations in foreign currency exchange rates in the future will not have amaterial adverse effect on revenues from international sales and,correspondingly, on our business, financial condition and results ofoperations. We have contracts negotiated in Japanese Yen and we maintain a bankaccount in Japanese Yen for purchasing portions of our inventories and supplies.The balance of this Japanese Yen account at March 31, 2004 was approximately$43.1 million. Beginning in the first quarter of 2004, we hedge certainJapanese Yen-denominated balance sheet exposures against future movements inforeign currency exchange rates by using foreign currency forward contracts.Gains and losses on these fair value hedges are intended to offset gains andlosses from the revaluation of our Japanese Yen-denominated recognizedliabilities. In accordance with Statement of Financial Accounting Standards No.133 (“SFAS 133”), “Accounting for Derivative Instruments and HedgingActivities,” we recognize derivative instruments and hedging activities aseither assets or liabilities on the balance sheet and measure them at fairvalue. The net result of gains and losses on contracts and revaluation includedin interest and other income (expense) was insignificant for the three monthsended March 31, 2004. Our foreign currency forward contracts generally maturewithin three months. We do not intend to utilize derivative financialinstruments for trading purposes. There were no foreign currency forwardcontracts held at March 31, 2004.

 

We believe that our existing cash and cashequivalents, short-term investments and cash from operations will be sufficientto finance our operations through at least the next 12 months. As of March31, 2004, we had cash, restricted cash and short-term investments, of$797.1 million and lines of credit totaling $390.5 million available forfuture borrowings. $336.2 million of these expire in 2004 and $54.3 million ofthese facilities expire between 2005 and 2010. However, in the event that ourcurrent cash balances, future cash flows from operations and current lines ofcredit are not sufficient to meet our obligations or strategic needs or in theevent that market conditions are favorable, we would consider raisingadditional funds in the capital or equity markets. If additional financing isneeded, there can be no assurance that such financing will be available to uson commercially reasonable terms, or at all.

 

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*Income taxes*

 

Oursubsidiaries and joint ventures located in China enjoy tax benefits which aregenerally available to foreign investment enterprises, including full exemptionfrom national enterprise income tax for two years starting from the firstprofit making year and/or a 50% reduction in national income tax rate for thefollowing three years. In addition, local enterprise income tax is often waivedor reduced during this tax holiday/incentive period. Under current regulationsin China, foreign investment enterprises that have been accredited astechnologically advanced enterprises are entitled to additional tax incentives.These tax incentives vary in different locales and could include preferentialnational enterprise income tax treatment at 50% of the usual rates fordifferent periods of time. The tax holidays discussed above are applicable toUTStarcom (Chongqing) Co., Ltd. (“CUTS”), UTStarcom Telecom Co., Ltd. (“HUTS”),Hangzhou UTStarcom Telecom Co., Ltd. (“HSTC”) and UTStarcom China Co., Ltd.(“UTSC”), our active subsidiaries in China, as those entities qualify asaccredited technologically advanced enterprises. Specifically, HUTS currentlyenjoys a 15% tax rate that will continue indefinitely provided they remain as atechnologically advanced enterprise and the Government does not change the taxlaws. UTSC currently enjoys a 10% holiday tax rate that expires on December 31,2005. HSTC and CUTS are currently exempt from income tax until December 31,2004, at which point they will be subject to a 7.5% tax rate, which will expireon December 31, 2007.

 

We are working to implement a research and development cost sharingarrangement among our key worldwide entities. The purpose of cost sharing is to enable its participants to jointlydevelop and own intangibles.  Underresearch and development cost sharing, the total research and developmentexpense is paid by cost-sharing participants in proportion to eachparticipant’s future sales.  The benefitis that there is greater certainty with respect to transfer pricing and definedownership of IP. Cost sharing in China is a new concept and we are workingclosely with the China Tax and Regulatory Authorities to gain approval for costsharing.

 

*Contractualobligations and other commercial commitments*

 

Our obligationsunder contractual obligations and commercial commitments are primarily withregard to leasing arrangements and standby letters of credit and are as follows:

 
|                           |   | **March 31,  2004  Payments Due by Period** |    |
|--------------------------------|--------|---------------------------------------------|---------|
| **(in  thousands)**            |   | **Total**                                   |    | **Less than  1 year** |   | **1-3 years** |   | **3-5 years** |   |
| *Contractual Obligations*      |   |                                        |    |   |   |   |   |   |   |
| Notes Payable`                 |   | $                                           | 1,044   |   | $ | 1,044 |   | $ | — |   | $ | — |   |
| Convertible Subordinated Notes |   | $                                           | 402,500 |   | $ | — |   | $ | — |   | $ | 402,500 |   |
| Operating leases               |   | $                                           | 24,104  |   | $ | 10,183 |   | $ | 13,489 |   | $ | 432 |   |
| *Other Commercial Commitments* |   |                                        |    |   |   |   |   |   |   |
| Standby letters of credit      |   | $                                           | 26,863  |   | $ | 26,863 |   | $ | — |   | $ | — |   |
| Purchase commitments           |   | $                                           | 991     |   | $ | 991 |   | — |   | — |   |

 

Certain salescontracts include provisions under which customers would be indemnified by usin the event of, among other things, a third-party claim against the customerfor intellectual property rights infringement related to our products. Thereare no limitations on the maximum potential future payments under theseguarantees. We have not accrued any amounts in relation to these provisions asno such claims have been made and we believe we have valid enforceable rightsto the intellectual property embedded in our products.

 

Our $402.5 million of convertiblesubordinated notes, due March 1, 2008, bear interest at a rate of 7/8% per annum, payable semiannually on May 1 and September 1,are convertible into the Company’s common stock at a conversion price of $23.79per share and are subordinated to all present and future senior debt of theCompany. The principal is due only at maturity of the notes.

 

We issue standby letters of credit primarilyto support international sales activities outside of China. When we submit abid for a sale, often the potential customer will require that we issue a bidbond or a standby letter of credit to demonstrate our commitment through thebid process. In addition, we may be required to issue standby letters of creditas guarantees for advance customer payments upon contract signing orperformance guarantees. The standby letters of credit usually expire six tonine months from date of issuance without being drawn by the beneficiarythereof.

 

*Accounts receivabletransferred to notes receivable*

 

We accept commercial notes receivable, withmaturity dates between three and six months, from our customers in China in thenormal course of business. We may discount these notes with bankinginstitutions in China. A sale of these notes is reflected as a

 

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reductionof notes receivable, and the proceeds of the settlement of these notes areincluded in cash flows from operating activities in the consolidated statementof cash flows. There were zero and $19.3 million of notes receivable soldduring the three months ended March 31, 2004 and 2003, respectively. Thesenotes are not included in our consolidated balance sheets as the criteria forsale treatment established by Statement of Financial Accounting Standards No. 140,“Accounting for Transfers and Servicing of Financial Assets and Extinguishmentof Liabilities” (“SFAS 140”), has been met. Under SFAS 140, upon atransfer, the transferor or entity must derecognize financial assets whencontrol has been surrendered and the transferee obtains control over theassets. In addition, the transferred assets have been isolated from thetransferor, beyond the reach of its creditors, and the transferee has theright, without conditions or constraints, to pledge or exchange the assets ithas received. Notes receivable available for sale were $43.8 million and$11.4 million at March 31, 2004 and December 31, 2003, respectively.

 

*Joint Venture Funding*

 

Pursuant to the jointventure agreement with Matsushita, we are jointly liable for the lossesincurred in the operations of the joint venture up to the maximum of ourinvestment in the entity.  At March 31,2004, the losses had exceeded this amount; however, we had accrued additionallosses of approximately $1.0 million due to our commitment to fund anadditional investment of $9.3 during the second quarter of 2004.

 

*Investmentcommitments*

 

As of March 31, 2004, we had invested a totalof $2.0 million in Global Asia Partners L.P. that is recorded as along-term investment. The fund size is anticipated to be $10.1 million andthe fund was formed to make private equity investments in private or pre-IPOtechnology and telecommunications companies in Asia. We have a commitment toinvest up to a maximum of $5.0 million. The remaining amount is due atsuch times and in such amounts as shall be specified in one or more futurecapital calls to be issued by the general partner.

 

*Purchase commitments*

 

We are obligated to purchase raw materialsand work-in-process inventory under various orders from one supplier, all ofwhich should be fulfilled without adverse consequences material to ouroperations or financial condition. As of March 31, 2004 total open commitmentsunder these purchase orders were approximately $1.0 million.

 

**CRITICAL ACCOUNTINGPOLICIES AND ESTIMATES**

 

Our financial condition and results ofoperations are based on certain critical accounting policies and estimates,which include judgments, estimates, and assumptions on the part of management.Estimates are based on historical experience, knowledge of economic and marketfactors and various other assumptions that management believes to be reasonableunder the circumstances. Actual results may differ from those estimates. Thefollowing summary of critical accounting policies and estimates highlightsthose areas of significant judgment in the application of our accountingpolicies that affect our financial condition and results of operations.

 

**Revenue Recognitionand Product Warranty**

 

We recognize revenues from sales oftelecommunications equipment when persuasive evidence of an arrangement exists,delivery of the product has occurred, customer acceptance has been obtained,the fee is fixed or determinable and collectability is reasonably assured. Ifthe payment due from the customer is not fixed or determinable due to extendedpayment terms, revenue is recognized as payments become due from the customer,assuming all other criteria for revenue recognition are met. Normal paymentterms differ for various reasons amongst different customer regions dependingupon the common business practices for customers within a region. Shipping andhandling costs are recorded as revenues and costs of revenues. Any expectedlosses on contracts are recognized immediately.

 

Final acceptance is required in our complexmultiple element contractual arrangements since installation stretches over atime frame of six to twelve months, terms and deliverables are not finalizeduntil project completion, and customers extensively test the systems afterinstallation. Final acceptance indicates that the customer has fully accepteddelivery of equipment and that we are entitled to the full payment. We will notrecognize revenue before final acceptance is granted by the customer ifacceptance is considered substantive to the transaction. Additionally, we donot recognize revenue when cash payments are received from customers fortransactions that do not have the customer’s final acceptance. We record thesecash receipts as customer advances, and defer revenue recognition until finalacceptance is received.

 

Sales may be generated from complexcontractual arrangements that require significant revenue recognitionjudgments, particularly in the areas of multiple element arrangements. Wheremultiple elements exist in an arrangement, the arrangement fee is allocated tothe different elements based upon verifiable objective evidence of the fairvalue of the elements, as governed under EITF 00-21 and SEC Staff AccountingBulletin No. 104 “SAB 104.” Multiple element arrangements primarilyinvolve the sale of PAS or iPAS equipment with handsets, installation andtraining and the provision of such equipment to different locations for thesame customer. 

 

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Revenue isrecognized as each element is earned, namely upon installation and acceptanceof equipment or delivery of handsets; provided that the fair value of theundelivered element(s) has been determined, the delivered element hasstand-alone value, there is no right of return on delivered element(s), and weare in control of delivery of the undelivered element(s).

 

Where multipleelements exist in an arrangement that includes software, and the software isconsidered more than incidental to the equipment or services in thearrangement, software and software-related elements are recognized under theprovisions of Statement of Position 97-2, as amended, and Emerging Issues TaskForce Issue No. 03-05. The Company allocates revenues to each element ofsoftware arrangements based on vendor-specific objective evidence (“VSOE”).VSOE of each element is based on the price charged when the same element issold separately. We use the residual method to recognize revenue when anarrangement includes one or more elements to be delivered at a future date andVSOE of the fair value of all the undelivered elements exists. Under theresidual method, the fair value of the undelivered elements is deferred and theremaining portion of the arrangement fee is recognized as revenue. If evidenceof fair value of one or more undelivered elements does not exist, revenue isdeferred and recognized when delivery of those elements occurs or when fairvalue can be established.

 

We also sell products, primarily handsets,through resellers. Revenue is generally recognized when the standard priceprotection period has lapsed, which ranges from 30 to 90 days. Ifcollectability cannot be reasonably assured in a reseller arrangement, revenueis recognized upon sell-through to the end customer and receipt of cash. InChina, there may be additional obligations in reseller arrangements such asinventory rotation, or stock exchange rights on the product. As such, revenueis recognized in accordance with Statement of Financial Accounting StandardsNo. 48 “Revenue Recognition When Right of Return Exists.” We havedeveloped reasonable estimates for stock exchanges. Estimates are derived fromhistorical experience with similar types of sales of similar products.

 

We recognize revenue for system integration,installation and training upon completion of performance if all other revenuerecognition criteria are met. Other service revenue, such as that related tomaintenance and support contracts, is recognized ratably over the contractterm.

 

The assessment of collectability is also afactor in determining whether revenue should be recognized. We assesscollectability based on a number of factors, including payment history and thecreditworthiness of the customer. We do not request collateral from ourcustomers in China. In global sales outside of China, we often require lettersof credit that can be drawn on demand if a customer defaults on its payment. Ifwe determine that collection of a fee is not reasonably assured, we recognizerevenue upon receipt of cash.

 

Because of the nature of doing business inChina and other emerging markets, our billings and/or customer payments may notcorrelate with the contractual payment terms and we generally do not enforcecontractual payment terms on complex, multiple-element arrangements prior tofinal acceptance. Accordingly, these accounts receivable are not booked untilwe recognize the related customer revenue. Advances from customers arerecognized when we have collected cash from the customer prior to recognizingrevenue.

 

We provide a warranty on our equipment andhandset sales for a period generally ranging from one to three years from thetime of final acceptance. We provide for the expected cost of productwarranties at the time that we recognize revenue, based on our assessment ofpast warranty experience. We continually monitor the level of our warrantyexpenses. If, however, there were to be a material adverse change in ourproduct failure rates, an additional warranty provision would be required.Historically, our warranty experience has been within our expectations.

 

**Receivables**

 

We are required to estimate thecollectability of our trade receivables and notes receivable. We maintain anallowance for doubtful accounts for the estimated losses on the tradereceivables and notes receivable. We assess collectability of the receivable bydetermining whether the creditworthiness of the customer has deteriorated andcould result in an inability to collect payment; if collectability is doubtful,we record an allowance against the receivable. If the financial condition ofour customers was to deteriorate and their ability to make payments suffers asa result, we may need to increase our allowances for our receivables.

 

**Inventories**

 

Inventories consist of inventories held atour manufacturing facility, warehouses or at customer sites prior to signing ofcontracts. We may ship inventory to existing customers that require additionalequipment to expand their existing networks prior to the signing of anexpansion contract. Our inventories are stated at the lower of cost or netrealizable value, net of write-downs for excess, slow moving and obsoleteinventory. Inventory is written down for estimated obsolescence or unmarketableinventory equal to the difference between inventory cost and the estimatedmarket value. Write-downs are based on our assumptions about future marketconditions and customer demand, including projected changes in average sellingprices resulting from competitive pricing pressures. We continually monitorinventory valuation for potential losses and obsolete inventory at ourmanufacturing facilities as well as at customer sites.

 

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**Deferredcosts/Inventories at Customer Sites Under Contracts**

 

Inventories at customer sites under contractsawaiting final acceptance are classified as deferred costs, separate from whatwe have historically considered inventory. These are stated at the lower ofcost or net realizable value, net of reserves based upon assessment ofpotential losses and obsolescence during the lengthy acceptance process. Thetitle and risk of loss of this inventory is transferred to the customer upondelivery. Revenue and cost of sales are recorded when we receive finalacceptance from the customer.

 

**Research andDevelopment and Capitalized Software Development Costs**

 

Our research and development costs arecharged to expense as incurred. We capitalize software development costsincurred in the development of software that will ultimately be sold betweenthe time technological feasibility has been attained and the related product isready for release. Management judgment is required in assessing technologicalfeasibility, expected future revenues, estimated product lives and changes inproduct technologies, and the ultimate recoverability of our capitalizedsoftware development costs.

 

###### **Deferred Income Taxes**

 

We recognize deferred income taxes as thedifference between the tax bases of assets and liabilities and their financialstatement amounts based on enacted tax rates. Management judgment is requiredin the assessment of the recoverability of our deferred tax assets based on ourassessment of projected taxable income. Numerous factors could affect ourresults of operations in the future. If there was a significant decline in ourfuture operating results, our assessment of the recoverability of our deferredtax assets would need to be revised, and any such adjustment to our deferredtax assets would be charged to income in that period. If necessary, we record avaluation allowance to reduce deferred tax assets to an amount managementbelieves is more likely than not to be realized.

 

**Goodwill andIntangibles**

 

We have recorded goodwill and intangibleassets in connection with our business acquisitions. Management judgment isrequired in the assessment of the related useful lives, assumptions regardingour ability to successfully develop and ultimately commercialize acquiredtechnology, and assumptions regarding the fair value and the recoverability ofthese assets. We perform our annual goodwill impairment review in the fourthquarter of each year or when changes in circumstances indicate a potentialimpairment. We currently operate as a single reportable segment withoutreporting units, as our management evaluates performance, make operatingdecisions and allocates resources based on consolidated financial data. Assuch, we determine whether impairment to goodwill is necessary on aconsolidated basis. When assessing potential impairment to goodwill, we compareour book value to our fair market value. Fair market value is our marketcapitalization at the date impairment is assessed. Historically, our fairmarket value has exceeded our book value and no impairment has been necessary.

 

**Long-Term Investments**

 

We have investedin a fund focused on investments in Internet companies in China and a fundfocused on investments in companies in Asia undergoing restructuring orbankruptcy procedures. We have also invested directly in a number of privatetechnology-based companies in the early stages of development and in technologycompanies publicly listed or traded on Nasdaq and NYSE. While quoted marketprices are readily available to determine the fair value of our investments inthese publicly traded companies, management judgment is required to determinewhen losses are other than temporary. Furthermore, management judgment isrequired in evaluating the carrying value of our private company investmentsfor possible impairment. For our private technology company investments, weassess impairment based on an evaluation of the achievement of businessobjectives and milestones, the financial condition and prospects of thesecompanies and other relevant factors. We continually monitor these investmentsfor impairment, and charge to income any impairment amounts in the period sucha determination is made.

 

**RECENT ACCOUNTING PRONOUNCEMENTS**

 

In November 2003, the EITF issued EITF No. 03-*6 “ Participating Securities and the Two-Class Methodunder FASB Statement No. 128,”* which provides for a two-class methodof calculating earnings per share computations that relate to certainsecurities that would be considered to be participating in conjunction withcertain common stock rights. This guidance would be applicable starting withthe second quarter beginning April 1, 2004. We are currently evaluating thepotential impact of this pronouncement on our financial statements.

 

**FACTORS AFFECTING FUTURE OPERATING RESULTS**

 

**RISKS RELATED TO OUR COMPANY**

 

***Our future product sales are unpredictableand, as a result, our operating results are likely to fluctuate from quarter toquarter.***

 

Our quarterly and annual operating resultshave fluctuated in the past and are likely to fluctuate in the future due to avariety of factors, some of which are outside of our control. Factors that mayaffect our future operating results, in addition to those described

 

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below,include:

 

•                                          the timing and size of the orders for ourproducts;

 

•                                          changes in our customers’ subscriber growth rate;

 

•                                          the lengthy and unpredictable sales cyclesassociated with sales of our products;

 

•                                          cancellation, deferment or delay in implementationof large contracts;

 

•                                          our revenue recognition, which is based onacceptance, is unpredictable;

 

•                                          a seasonal reoccurrence of an outbreak of severeacute respiratory syndrome (SARS) or other illnesses affecting areas in whichwe operate;

 

•                                          the decline in business activity we typicallyexperience during the Lunar New Year, which leads to decreased sales during ourfirst fiscal quarter relative to historical and expected year-long trends; and

 

•                                          changes in accounting rules, such as recordingexpenses related to employee stock option compensation plans.

 

As a result of these and other factors,period-to-period comparisons of our operating results are not necessarilymeaningful or indicative of future performance. Furthermore, it is possiblethat in some future quarters our operating results will fall below theexpectations of securities analysts or investors. If this occurs, the tradingprice of our common stock could decline.

 

***Competition in our markets may lead toreduced prices, revenues and market share.***

 

We believe that we will continue to faceintense competition from both domestic and international companies in ourtarget markets, many of which may operate under lower cost structures or may begiven preferential treatment by applicable governmental regulators and policiesand have much larger sales forces than we do. Additionally, other companies notpresently offering competing products may also enter our target markets. Manyof our competitors have significantly greater financial, technical, productdevelopment, sales, marketing and other resources than we do. As a result, ourcompetitors may be able to respond more quickly to new or emerging technologiesand changes in service provider requirements. Our competitors may also be ableto devote greater resources than we can to the development, promotion and saleof new products. These competitors may be able to offer significant financingarrangements to service providers, which may give them a competitive advantagein selling systems to service providers with limited financial and currencyresources. In many of the developing markets in which we operate or intend tooperate, relationships with local governmental telecommunications agencies areimportant to establish and maintain. In many such markets, our competitors mayhave or be able to establish better relationships with local governmentaltelecommunications agencies than we have, which could result in their abilityto influence governmental policy formation and interpretation to theiradvantage. Additionally, our competitors might have better relationships withtheir third-party suppliers and obtain component parts at a reduced rate,allowing them to offer their end products at reduced prices. Increasedcompetition is likely to result in price reductions, reduced gross profit as apercentage of net sales and loss of market share, any one of which couldmaterially harm our business, financial condition, cash flows, and results ofoperations.

 

***Theaverage selling prices of our products may decrease, which may reduce ourrevenues and our gross profit. As a result, we must introduce new products andreduce our costs in order to maintain profitability.***

 

The average selling prices for communicationsaccess and switching systems and handsets have historically declined as aresult of a number of factors, including:

 

•                                          increased competition;

 

•                                          aggressive price reductions by competitors; and

 

•                                          rapid technological change.

 

The average selling prices of our productsmay continue to decrease in the future in response to product introductions byus or our competitors or other factors, including price pressures fromcustomers. Therefore, we must continue to develop and introduce new productsand enhancements to existing products that incorporate features that can besold at higher average selling prices. Failure to do so could cause ourrevenues and gross profit to decline.

 

Our cost reduction efforts may not allow usto keep pace with competitive pricing pressures or lead to improved grossprofit, as a percentage of net sales. In order to be competitive, we mustcontinually reduce the cost of manufacturing our products through design and engineeringchanges. We may not be successful in these efforts or in delivering ourproducts to market in a timely manner. In addition, 

 

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anyredesign may not result in sufficient cost reductions to allow us to reduce theprices of our products to remain competitive or to improve or maintain ourgross profit, as a percentage of net sales, which would cause our financialresults to suffer.

 

***Salesin China have accounted for most of our total sales, and our business,financial condition and results of operations are to a significant degreesubject to economic, political and social events in China.***

 

Approximately $570.6 million, or 92%, and$268.9 million, or 81%, of our net sales for the three months ended March 31,2004 and 2003, respectively, occurred in China. While we anticipate expansioninto other foreign markets, a significant majority of our net sales will bederived from China for the foreseeable future. In addition, we plan to continueto make further investments in China in the future. Therefore, our business,financial condition and results of operations are to a significant degreesubject to economic, political, legal and social developments and other eventsin China. Please read the risks detailed below under the heading “Risks Relatedto Conducting Business in China” for additional information about the risks weface in connection with our China operations.

 

***Ourmarket is subject to rapid technological change, and to compete effectively, wemust continually introduce new products and product enhancements that achievemarket acceptance.***

 

The market for communications equipment ischaracterized by rapid technological developments, frequent new productintroductions and evolving industry and regulatory standards. Our success willdepend in large part on our ability to enhance our network and broadband accessand switching technologies and develop and introduce new products and productenhancements that anticipate changing service provider requirements andtechnological developments. We may need to make substantial capitalexpenditures and incur significant research and development costs to developand introduce new products and enhancements. If we fail to develop andintroduce new products or enhancements to existing products that effectivelyrespond to technological change on a timely basis, our business, financialcondition and results of operations could be materially adversely affected.Moreover, from time to time, our competitors or we may announce new products orproduct enhancements, technologies or services that have the potential toreplace or shorten the life cycles of our products and that may cause customersto defer purchasing our existing products, resulting in inventory obsolescence.Future technological advances in the communications industry may diminish orinhibit market acceptance of our existing or future products or render ourproducts obsolete.

 

Even if we are able to develop and introducenew products, they may not gain market acceptance. Market acceptance of ourproducts will depend on various factors, including:

 

•                                          our ability to obtain necessary approvals fromregulatory organizations within the countries in which we operate and for anynew technologies that we introduce;

 

•                                          the length of time it takes service providers toevaluate our products, causing the timing of purchases to be unpredictable;

 

•                                          our products being compatible with legacytechnologies and standards existing in previously deployed network equipment;

 

•                                          our ability to attract customers who may havepreexisting relationships with our competitors;

 

•                                          product cost relative to performance; and

 

•                                          the level of customer service available to supportnew products.

 

If our products fail to obtain market acceptance in a timely manner,our business could suffer.

 

***Wedepend on some sole source and other key suppliers, as well as internationalsources, for handsets, base stations, components and materials used in ourproducts. If we cannot obtain adequate supplies of high quality products atcompetitive prices or in a timely manner from these suppliers or sources, ourcompetitive position, reputation and business could be harmed.***

 

We have contracts with a single supplier orwith a limited group of suppliers to purchase some components and materialsused in our products. If any supplier is unwilling or unable to provide us withhigh-quality components and materials in the quantities required and at thecosts specified by us, we may not be able to find alternative sources onfavorable terms, in a timely manner, or at all. Our inability to obtain or todevelop alternative sources if and as required could result in delays orreductions in manufacturing or product shipments. From time to time, therecould be shortages of different products or components. For example, in 2001and 2002 there was a worldwide shortage of handset components resulting fromour third-party manufacturers’ inability to assemble and manufacture asufficient quantity of handsets to keep pace with consumer demand. Moreover,our suppliers may supply us with inferior quality products. If an inferiorproduct supplied by a third party is embedded in our end product and causes aproblem, it might be difficult to identify the source of the problem as beingdue to the component parts. If any of these events occur, our competitiveposition, reputation and business could suffer.

 

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Our ability to source a sufficient quantityof high-quality, cost-effective components used in our products may also belimited by import restrictions and duties in the foreign countries in which wemanufacture our products. We require a significant number of importedcomponents to manufacture our products, and imported electronic components andother imported goods used in the operation of our business may be limited by avariety of permit requirements, approval procedures, import duties andregistration requirements. Moreover, import duties on such components increasethe cost of our products and may make them less competitive.

 

***Ifwe seek to secure additional financing and are not able to do so, our abilityto expand strategically may be limited. If we are able to secure additionalfinancing, our stockholders may experience dilution of their ownership interest,or we may be subject to limitations on our operations and increased leverage.***

 

We currently anticipate that our availablecash resources, which include existing cash and cash equivalents, short-terminvestments and cash from operations, will be sufficient to meet ouranticipated needs for working capital and capital expenditures for theforeseeable future. If we are unable to generate sufficient cash flows fromoperations, we may need to raise additional funds to develop new or enhancedproducts, respond to competitive pressures, take advantage of acquisitionopportunities or raise capital for strategic purposes. If we raise additionalfunds through the issuance of equity securities, our stockholders willexperience dilution of their ownership interest, and the newly issuedsecurities may have rights superior to those of common stock. If we raiseadditional funds by issuing debt, we may be subject to limitations on ouroperations and increase our leverage. For example, in connection with the sale ofconvertible debt securities in March 2003, we incurred $402.5 millionof indebtedness. As a result of this indebtedness, our principal and interestpayment obligations have increased substantially. The degree to which we areleveraged could materially and adversely affect our ability to obtain financingfor working capital, acquisitions or other purposes and could make us morevulnerable to industry downturns and competitive pressures. Our ability to meetour debt service obligations will be dependent upon our future performance,which will be subject to financial, business and other factors affecting ouroperations, many of which are beyond our control. Finally, additional sourcesof financing may not be available on reasonable terms or at all if and when werequire it, which could harm our business.

 

***Ourrecent growth has strained our resources, and if we are unable to manage andsustain our growth, our operating results will be negatively affected.***

 

We have recently experienced a period ofrapid growth and anticipate that we must continue to expand our operations toaddress potential market opportunities. Our expansion has placed and willcontinue to place a significant strain on our management, operational,financial and other resources. To manage our growth effectively, we will needto take various actions, including:

 

•                                          enhancing management information systems andforecasting procedures;

 

•                                          further developing our operating, administrative,financial and accounting systems and controls;

 

•                                          managing our working capital and sources offinancing to fund our expansion;

 

•                                          maintaining close coordination among ourengineering, accounting, finance, marketing, sales and operationsorganizations;

 

•                                          expanding, training and managing our employeebase;

 

•                                          managing the expansion of both our direct andindirect sales channels in a cost-efficient and competitive manner; and

 

•                                          fully review our new customers’ credit historiesand ensure their financial stability before finalizing contracts.

 

If we fail to implement or improve systems orcontrols or to manage any future growth and expansion effectively, our businesscould suffer.

 

***Oursuccess is dependent on continuing to hire and retain qualified personnel, andif we are not successful in attracting and retaining these personnel, ourbusiness will suffer.***

 

The success of our business depends insignificant part upon the continued contributions of key technical and seniormanagement personnel, many of whom would be difficult to replace. Inparticular, our success depends in large part on the knowledge, expertise andservices of Hong Liang Lu, our Chairman of the Board, President and ChiefExecutive Officer, and Ying Wu, our Chairman and Chief Executive Officer ofChina Operations. The loss of any key employee, the failure of any key employeeto perform satisfactorily in his or her current position or our failure toattract and retain other key technical and senior management employees couldhave a significant negative impact on our operations.

 

To effectively manage our recent growth aswell as any future growth, we will need to recruit, train, assimilate, motivateand retain qualified employees both locally and internationally. Competitionfor qualified employees is intense, and the process of recruiting

 

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personnelwith the combination of skills and attributes required to execute our businessstrategy can be difficult, time-consuming and expensive. As we grow globally,we must implement hiring and training processes that are capable of quicklydeploying qualified local residents to knowledgeably support our products andservices. Alternatively, if there is an insufficient number of qualified localresidents available, we might incur substantial costs importing expatriates toservice new global markets. For example, we have historically experienceddifficulty finding qualified accounting personnel knowledgeable in both U.S.and Chinese accounting standards who are Chinese residents. If we fail toattract, hire, assimilate or retain qualified personnel, our business would beharmed.

 

Competitors and others have in the past, andmay in the future, attempt to recruit our employees. In addition, companies inthe telecommunications industry whose employees accept positions with competitorsfrequently claim that the competitors have engaged in unfair hiring practices.We may be the subject of these types of claims in the future as we seek to hirequalified personnel. Some of these claims may result in material litigation anddisruption to our operations. We could incur substantial costs in defendingourselves against these claims, regardless of their merit.

 

***Anyacquisitions that we undertake could be difficult to integrate, disrupt ourbusiness, dilute our stockholders and harm our operating results.***

 

We may acquire other businesses, products andtechnologies. For example, on May 23, 2003, we purchased certain assetsand liabilities of the CommWorks division of 3Com Corporation for$100.0 million in cash and incurred related transaction and other relatedcosts of $9.3 million. Any anticipated benefits of an acquisition may notbe realized. We have in the past and will continue to evaluate acquisitionprospects that would complement our existing product offerings, augment ourmarket coverage, enhance our technological capabilities, or that may otherwiseoffer growth opportunities. Acquisitions may result in dilutive issuances ofequity securities, use of our cash resources, the incurrence of debt and theamortization of expenses related to intangible assets. In addition,acquisitions involve numerous risks, including difficulties in the assimilationof operations, technologies, products and personnel of the acquired company,diversion of management’s attention from other business concerns, risks ofentering markets in which we have no direct or limited prior experience, thepotential loss of key employees of the acquired company, unanticipated costsand, in the case of the acquisition of financially troubled businesses,challenges as to the validity of such acquisitions from third party creditorsof such businesses.

 

***Wemay be unable to adequately protect the loss or misappropriation of ourintellectual property, which could substantially harm our business.***

 

We rely on a combination of patents,copyrights, trademarks, trade secret laws and contractual obligations toprotect our technology. We have applied for patents in the United States andinternationally. Additional patents may not be issued from our pending patentapplications, and our issued patents may not be upheld. In addition, we have,from time to time, chosen to abandon previously filed applications. Moreover,we may face difficulties in registering our existing trademarks in newjurisdictions in which we operate. We cannot guarantee that the intellectualproperty protection measures that we have taken will be sufficient to preventmisappropriation of our technology or trademarks or that our competitors willnot independently develop technologies that are substantially equivalent or superiorto ours. In addition, the legal systems of many foreign countries do notprotect or honor intellectual property rights to the same extent as the legalsystem of the United States. For example, in China, the legal system ingeneral, and the intellectual property regime in particular, are still in thedevelopment stage. It may be very difficult, time-consuming and costly for usto attempt to enforce our intellectual property rights in these jurisdictions.

 

***Wemay be subject to claims that we infringe the intellectual property rights ofothers, which could substantially harm our business.***

 

The industry in which we compete is movingtowards aggressive assertion, licensing, and litigation of patents and otherintellectual property rights. From time to time, we have become aware of thepossibility or have been notified that we may be infringing certain patents orother intellectual property rights of others. Regardless of their merit,responding to such claims could be time consuming, divert management’s attentionand resources and cause us to incur significant expenses. In addition, althoughsome of our supplier contracts provide for indemnification from the supplierwith respect to losses or expenses incurred in connection with any infringementclaim, some of our contracts do not provide for such protection. Moreover,certain of our sales contracts provide that we must indemnify our customersagainst claims by third parties for intellectual property rights infringementrelated to our products. There are no limitations on the maximum potentialfuture payments under these guarantees. Therefore, we may incur substantialcosts related to any infringement claim, which may substantially harm ourresults of operations and financial condition.

 

We may, in the future, become subject tolitigation to defend against claimed infringements of the rights of others orto determine the scope and validity of the proprietary rights of others. Futurelitigation may also be necessary to enforce and protect our trade secrets and otherintellectual property rights. Any intellectual property litigation orthreatened intellectual property litigation could be costly, and adversedeterminations or settlements could result in the loss of our proprietaryrights, subject us to significant liabilities, require us to seek licenses fromor pay royalties to third parties which may not be available on commerciallyreasonable terms, if at all, and/or prevent us from manufacturing or sellingour products, which could cause disruptions to our operations.

 

In the event that there is a successful claimof infringement against us and we fail to develop non-infringing technology orlicense the propriety rights on commercially reasonable terms and conditions,our business, results of operations or financial condition

 

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could bematerially and adversely impacted.

 

***Our multinational operations subject us tovarious economic, political, regulatory and legal risks.***

 

We market and sell our products globally, withthe majority of our sales made in China. The expansion of our existingmultinational operations and entry into new markets will require significantmanagement attention and financial resources. Multinational operations aresubject to a variety of risks, such as:

 

•                                          the burden of complying with a variety of foreignlaws and regulations;

 

•                                          the burden of complying with United States lawsand regulations for foreign operations, including the Foreign Corrupt PracticesAct;

 

•                                          difficulty complying with continually evolving andchanging global product and communications standards and regulations for bothour end products and their component technology;

 

•                                          market acceptance of our new products, includinglonger product acceptance periods in new markets into which we enter;

 

•                                          reliance on local original equipment manufacturers(OEMs), third-party distributors and agents to effectively market and sell ourproducts;

 

•                                          unusual contract terms required by customers indeveloping markets;

 

•                                          changes in local governmental control or influenceover our customers;

 

•                                          changes to import and export regulations,including quotas, tariffs, licensing restrictions and other trade barriers;

 

•                                          evolving and unpredictable nature of the economic,regulatory, competitive and political environments;

 

•                                          reduced protection for intellectual propertyrights in some countries;

 

•                                          longer accounts receivable collection periods; and

 

•                                          difficulties and costs of staffing and managingmultinational operations, including but not limited to internal control andcompliance.

 

***Wedo business in markets that are not fully developed, which subjects us tovarious economic, political, regulatory and legal risks unique to developingeconomies.***

 

Less developed markets present additionalrisks, such as the following:

 

•                                          customers that may be unable to pay for ourproducts in a timely manner or at all;

 

•                                          new and unproven markets for our products and thetelecommunications services that our products enable;

 

•                                          inconsistent infrastructure support;

 

•                                          lack of a large, highly trained workforce;

 

•                                          difficulty in controlling local operations fromour headquarters;

 

•                                          variable ethical standards and an increasedpotential for fraud;

 

•                                          unstable political and economic environments; and

 

•                                          a lack of a secure environment for our personnel,facilities and equipment.

 

In particular, these factors create thepotential for physical loss of inventory and operating assets. We have in thepast experienced cases of vandalism and armed theft of our equipment that hadbeen or was being installed in the field. If disruptions for any of thesereasons become too severe in any particular market, it may become necessary forus to terminate contracts and withdraw from that market and suffer theassociated costs and lost revenue.

 

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***We are subject to risks relating to currencyrate fluctuations and exchange controls.***

 

Because most of our sales are made in foreigncountries, we are exposed to market risk for changes in foreign exchange rateson our foreign currency-denominated accounts and notes receivable balances. Wedo not currently hedge our foreign currency-denominated transactions.Historically, the majority of our sales have been made in China and denominatedin Renminbi; as such, the impact of currency fluctuations of Renminbi thus farhas been insignificant as it is fixed to the U.S. dollar. However, in thefuture, China could choose to devalue the Renminbi versus the U.S. dollar, orthe Renminbi-U.S. dollar exchange rate could float, and the Renminbi coulddepreciate relative to the U.S. dollar. Fluctuations in currency exchange ratesin the future may have a material adverse effect on our results of operations.

 

We enter into transactions that may expose usto foreign currency rate fluctuation risk. Historically, the largest componentof our foreign currency exchange loss has resulted from our purchasinginventory denominated in foreign currencies. If we continue to purchaseinventory in foreign currencies, we may incur additional foreign currencyexchange losses, causing our operating results to suffer.

 

Moreover, some of the foreign countries inwhich we do business might impose currency restriction that may limit theability of our subsidiaries and joint ventures in such countries to obtain andremit foreign currency necessary for the purchase of imported components andmay limit our ability to obtain and remit foreign currency in exchange forforeign earnings. For example, China employs currency controls restrictingRenminbi conversion, limiting our ability to engage in currency hedgingactivities in China. Various foreign exchange controls may also make itdifficult for us to repatriate earnings, which could have a material adverseeffect on our ability to conduct business globally.

 

***Business interruptions could adversely affectour business.***

 

Our operations are vulnerable to interruptionby fire, earthquake, power loss, telecommunications failure, externalinterference with our information technology systems, incidents of terrorismand other events beyond our control. For example, our Hangzhou manufacturingfacility’s ability to produce sufficient products is dependent upon acontinuous power supply, and the power required to source our manufacturingoperations is inconsistent. The Hangzhou facility has in the past been subjectto power shortages, which has affected our ability to produce and shipsufficient products. We do not have a detailed disaster recovery plan, and theoccurrence of any events like these that disrupt our business could harm ouroperating results.

 

***We may suffer losses with respect toequipment held at customer sites, which could harm our business.***

 

We face the risk of loss relating to ourequipment held at customer sites. In some cases, our equipment held at customersites is under contract, pending final acceptance by the customer. We do nothold title or risk of loss on such equipment, as title and risk of loss aretypically transferred to the customer upon delivery of our equipment. However,we do not recognize revenue and accounts receivable with respect to the sale ofsuch equipment until we obtain acceptance from the customer. If we do notobtain final acceptance, we may not be able to collect the contract price andrecover this equipment or its associated costs. In other cases, particularly inChina, where governmental approval is required to finalize certain contracts,inventory not under contract may be held at customer sites. We hold title andrisk of loss on this inventory until the contracts are finalized and, as such,are subject to any losses incurred resulting from any damage to or loss of thisinventory. If our contract negotiations fail or if the government of Chinaotherwise delays approving contracts, we may not recover or receive payment forthis inventory. Moreover, our insurance may not cover all losses incurred ifour inventory at customer sites not under contracts is damaged prior tocontract finalization. If we incur a loss relating to inventory for any of theabove reasons, our operating results could be harmed.

 

***We have been named as a defendant insecurities litigation.***

 

We and various underwriters for our initialpublic offering are defendants in a purported shareholder class action. Thecomplaint alleges undisclosed improper underwriting practices concerning theallocation of IPO shares, in violation of the federal securities laws. Similarcomplaints have been filed concerning the IPOs of more than 300 companies, andthe litigation has been coordinated in United States District Court for theSouthern District of New York as In re Initial Public Offering SecuritiesLitigation, 21 MC 92. Although we believe we have valid defenses to the claimsagainst us and intend to defend the litigation vigorously, until the matter isresolved, it will be necessary for us to continue to expend time and financialresources on the matter. Moreover, an adverse judgment in the litigation couldmaterially harm our operations.

 

***Recently enacted and proposed changes insecurities laws and regulations are likely to increase our costs.***

 

The Sarbanes-Oxley Act of 2002 has requiredand will continue to require changes in some of our corporate governance andsecurities disclosure or compliance practices. That Act also requires the SECto promulgate new rules on a variety of subjects, in addition to rule proposalsalready made, and The Nasdaq National Market has revised its requirements forcompanies that are Nasdaq-listed. We expect these developments will require usto devote additional resources to our operational, financial and managementinformation systems procedures and controls to ensure our continued compliancewith current and future laws and regulations. We expect these

 

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developmentsto make it more difficult and more expensive for us to obtain director andofficer liability insurance, and we may be required to accept reduced coverage,increase our level of self-insurance, or incur substantially higher costs toobtain coverage. These developments could make it more difficult for us toattract and retain qualified members of our board of directors, or qualifiedexecutive officers. We are presently evaluating and monitoring regulatorydevelopments and cannot estimate the timing or magnitude of additional costs wemay incur as a result.

 

***Changes in accounting rules.***

 

Weprepare our financial statements in conformity with accounting principlesgenerally accepted in the United States of America. These principles aresubject to interpretation by the Securities and Exchange Commission and variousbodies formed to interpret and create appropriate accounting policies. A changein these policies can have a significant effect on our reported results and mayeven retroactively affect previously reported transactions. In particular,changes to Financial Accounting Standards Board (FASB) guidelines relating toaccounting for stock-based compensation will likely increase our compensationexpense, could make our net income less predictable in any given reportingperiod and could change the way we compensate our employees or cause otherchanges in the way we conduct our business.

 

**RISKS RELATED TO CONDUCTING BUSINESS IN CHINA**

 

***China’s governmental and regulatory reformsmay impact our ability to do business in China.***

 

The Chinese government, through the Ministryof Information Industry, the Chinese telecommunication industry’s regulatingbody, has broad discretion and authority over all aspects of thetelecommunications and information technology industry in China, with the powerto permit or prohibit the sales of any of our products. Since 1978, the Chinesegovernment has been in a state of evolution and reform. The reforms haveresulted in and are expected to continue to result in significant economic andsocial development in China. Many of the reforms are unprecedented orexperimental and may be subject to change or readjustment due to a variety ofpolitical, economic and social factors. While we anticipate that the basicprinciples underlying the reforms will remain unchanged, any of the followingchanges in China’s political and economic conditions and governmental policiescould have a substantial impact on our business:

 

•                                          the promulgation of new laws and regulations andthe interpretation of those laws and regulations;

 

•                                          inconsistent enforcement and application of thetelecommunications industry’s rules and regulations by the Chinese governmentbetween foreign and domestic companies;

 

•                                          the introduction of measures to control inflationor stimulate growth;

 

•                                          the introduction of new guidelines for tariffs andservice rates, which affect our ability to competitively price our products andservices;

 

•                                          changes in the rate or method of taxation;

 

•                                          the imposition of additional restrictions oncurrency conversion and remittances abroad; or

 

•                                          any actions which limit our ability to develop,manufacture, import or sell our products in China, or to finance and operateour business in China.

 

For example, in the year 2000, the Ministryof Information Industry temporarily halted deployment of our PAS systems andhandsets, pending its review of personal handyphone system (“PHS”)-basedtelecommunications equipment, a microcellular wireless communicationstechnology. The Ministry of Information Industry later allowed the continueddeployment of PHS-based systems, such as our PAS systems and handsets, inChina’s county-level cities, towns and villages but limited deployments withinlarge and medium-sized cities to very limited areas of dense population, suchas campuses, commercial buildings and special development zones. If in thefuture the Ministry of Information Industry determines to prohibit the sale ordeployment of our PAS systems and handsets or our other products, or if itimposes additional limitations on their sale, our business and financialcondition could suffer.

 

In addition to modifying the existingtelecommunications regulatory framework, the Chinese government is currentlypreparing a draft of a standard, national telecommunications law (the“Telecommunications Law”) to provide a uniform regulatory framework for thetelecommunications industry. We do not yet know the final nature or scope ofthe regulation that would be created if the Telecommunications Law is passed.Accordingly, we cannot predict whether it will have a positive or negativeeffect on us or on some or all aspects of our business.

 

***China’s changing economic environment mayimpact our ability to do business in China.***

 

Since 1978, the Chinese government has beenreforming the economic system in China to increase emphasis placed ondecentralization and the utilization of market forces in the development ofChina’s economy. These reforms have resulted in significant economic growth.However, any economic reform policies or measures in China may from time totime be modified or revised by the Chinese government. While we may be able tobenefit from the effects of some of these policies, these policies and othermeasures taken by the Chinese government to regulate the economy could alsohave a significant negative impact on economic conditions in China, which wouldresult in a negative impact on our business. More recently, China’s economicenvironment has been changing as a result of China’s entry into the World TradeOrganization (WTO), which was effective in December of 2001. Entry into the WTOrequires that China reduce tariffs and eliminate non-tariff barriers, includingquotas, licenses and other restrictions, by 2005 at the latest, and we cannotpredict the impact of these changes on China’s economy. Moreover, althoughChina’s entry into the WTO and the related relaxation of trade restrictions maylead to increased foreign investment, it may also lead to increased competitionin China’s markets from other

 

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foreign companies.If China’s entry into the WTO results in increased competition or has anegative impact on China’s economy, our business could suffer. In addition,although China is increasingly according foreign companies and foreigninvestment enterprises established in China the same rights and privileges asChinese domestic companies as a result of its admission into the WTO, speciallaws, administrative rules and regulations governing foreign companies andforeign investment enterprises in China may still place foreign companies at adisadvantage in relation to Chinese domestic companies and may adversely affectour competitive position.

 

***Uncertainties with respect to the Chineselegal system may adversely affect us.***

 

We conduct our business in China primarilythrough our wholly-owned subsidiaries incorporated in China. Our subsidiariesare generally subject to laws and regulations applicable to foreign investmentin China. Accordingly, our business might be affected by China’s developinglegal system. Since 1978, many new laws and regulations covering generaleconomic matters have been promulgated in China, and government policies andinternal rules promulgated by governmental agencies may not be published intime, or at all. As a result, we may operate our business in violation of newrules and policies without having any knowledge of their existence. Inaddition, there are uncertainties regarding the interpretation and enforcementof laws, rules and policies in China. The Chinese legal system is based on writtenstatutes, and prior court decisions have limited precedential value. Becausemany laws and regulations are relatively new and the Chinese legal system isstill evolving, the interpretations of many laws, regulations and rules are notalways uniform. Moreover, the relative inexperience of China’s judiciary inmany cases creates additional uncertainty as to the outcome of any litigation,and the interpretation of statutes and regulations may be subject to governmentpolicies reflecting domestic political changes. Finally, enforcement ofexisting laws or contracts based on existing law may be uncertain and sporadic,and it may be difficult to obtain swift and equitable enforcement, or to obtainenforcement of a judgment by a court of another jurisdiction. Any litigation inChina may be protracted and result in substantial costs and diversion ofresources and management attention.

 

***We only have trial licenses to sell certainof our network access products in China.***

 

Under China’s current regulatory structure,the communications products that we offer in China must meet government andindustry standards, and a network access license for the equipment must beobtained. Without a license, telecommunications equipment is not allowed to beconnected to public telecommunications networks or sold in China. Moreover, wemust ensure that the quality of the telecommunications equipment for which wehave obtained a network access license is stable and reliable, and will notlower the quality or performance of other installed licensed products. China’sState Council’s product quality supervision department, in concert with China’sMinistry of Information Industry, performs spot checks to track and supervisethe quality of licensed telecommunications equipment and publishes the resultsof such spot checks.

 

We have obtained a probationary networkaccess license for our mSwitch product, and after the trial period, weanticipate that an official network access license will be issued if the trialdemonstrates that mSwitch satisfies all the applicable government and industrystandards. However, we cannot be certain that we will receive this license.Moreover, we only have trial licenses for our PAS systems and handsets. We haveapplied for, but have not yet received, a final official network access licensefor our PAS systems and handsets. Based upon conversations with China’sMinistry of Information Industry, we understand that our PAS systems andhandsets are considered to still be in the trial period and that sales of ourPAS systems and handsets may continue to be made by us during this trialperiod, but that a license will ultimately be required. If we fail to obtainthe required licenses, we could be prohibited from making further sales of theunlicensed products, including our PAS systems and handsets, in China, whichwould substantially harm our business, financial condition and results ofoperations. The regulations implementing these requirements are not verydetailed, have not been applied by a court and may be interpreted and enforcedby regulatory authorities in a number of different ways. Our counsel in Chinahas advised us that China’s governmental authorities may interpret or apply theregulations with respect to which licenses are required and the ability to sella product while a product is in the trial period in a manner that isinconsistent with the information received by our counsel in China, and eitherof these conditions could have a material adverse effect on our business,financial condition and results of operations.

 

***IfChina Telecom or China Netcom obtains licenses allowing them to deliver mobileservices, our ability to sell our PAS mobile systems and handsets could beimpaired.***

 

China Telecom and China Netcom hold andoperate the fixed line telephone and data communications assets in China, andcurrently do not have the licenses necessary to offer mobile services. However,China’s media sources have widely reported that China’s Ministry of InformationIndustry may grant mobile licenses to the new China Telecom or China Netcom, orto both toward the end of 2004. Furthermore, it is anticipated that the mobilelicense granted by the government will be used for 3G mobile networkdeployments.

 

If China Telecom or China Netcom obtain 3Gmobile licenses, they may direct capital expenditures to build-out 3G networks,and capital expenditures to build-out PAS networks that utilize our existingproducts may decline. Moreover, they may elect not to deploy our PAS systemsand handsets or other mobile services that we may offer in the future. Inaddition, it is possible that current PAS frequency bands utilized by PASnetworks may be reallocated for use by 3G networks, which would have the effectof restricting or shutting down PAS networks. If this were to occur, we couldlose current and potential future customers for our products, and our financialcondition and results of operations could be significantly harmed.

 

37

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***Promotionalor incentive programs offered by mobile operators such as China Mobile andChina Unicom may adversely impact the competitiveness and pricing of our PASsystems and related products.***

 

The official tariffs and per-minute usagerates charged to mobile users in China are generally set by the Ministry ofInformation Industry and the National Development and Reform Commission, andare usually adhered to by mobile operators. However, from time to time, certainmobile operators such as China Mobile and China Unicom have offered specialpromotional pricing or incentives to customers, such as free incoming calls orfree mobile-to-mobile calls. The continued use of such incentive programs bymobile operators may adversely impact the competitiveness and pricing of ourPAS systems and related products and their rollout by the new China Telecom andChina Netcom. Such incentive programs may continue or be expanded in thefuture. We cannot be certain as to what impact such incentive programs may haveon our financial condition. However, it is possible that the continuation orexpansion of such programs may have a material adverse effect on our businessor results of operations.

 

***If tax benefits available to our subsidiarieslocated in China are reduced or repealed, our business could suffer.***

 

The Chinesegovernment is considering the imposition of a “unified” corporate income taxthat would phase out, over time, the preferential tax treatment to whichforeign investment enterprises, such as our company, are currently entitled.While it is not certain whether the government will implement such a unifiedtax structure or whether our company will be grandfathered into any new taxstructure, if a new tax structure is implemented, a new tax structure mayadversely affect our financial condition. Moreover, certain of our subsidiariesand joint ventures located in China enjoy tax benefits in China that aregenerally available to foreign investment enterprises. If these tax benefitsare reduced or repealed due to changes in tax laws, our business could suffer.We are currently applying for the ability to share research and developmentcosts among our key worldwide entities. This is a new concept in China, and we are working closely with theChina Tax and Regulatory Authorities to gain approval for this cost sharing. Ifthe cost sharing is not approved by China, our effective tax rate may increase.

 

**RISKS RELATED TO OUR STOCK PERFORMANCE AND**

**CONVERTIBLE DEBT SECURITIES**

 

***Our stock price is highly volatile.***

 

The trading price of our common stock hasfluctuated significantly since our initial public offering in March of 2000.Our stock price could be subject to wide fluctuations in the future in responseto many events or factors, including those discussed in the preceding riskfactors relating to our operations, as well as:

 

•                                          actual or anticipated fluctuations in operatingresults, actual or anticipated gross profit as a percentage of net sales,levels of inventory, our actual or anticipated rate of growth and our actual oranticipated earnings per share;

 

•                                          changes in expectations as to future financialperformance or changes in financial estimates or buy/sell recommendations ofsecurities analysts;

 

•                                          changes in governmental regulations or policies inChina, such as the temporary suspension of sales of our PAS systems thatoccurred in May and June of 2000, which caused our stock price to drop;

 

•                                          our, or a competitor’s, announcement of newproducts, services or technological innovations;

 

•                                          the operating and stock price performance of othercomparable companies; and

 

•                                          news and commentary emanating from the media,securities analysts or government bodies in China relating to us and to theindustry in general.

 

General market conditions and domestic orinternational macroeconomic factors unrelated to our performance may alsoaffect our stock price. For these reasons, investors should not rely on recenttrends to predict future stock prices or financial results. In addition,following periods of volatility in a company’s securities, securities classaction litigation against a company is sometimes instituted. This type oflitigation could result in substantial costs and the diversion of managementtime and resources.

 

In addition, public announcements by ChinaTelecom and China Netcom, each of which exert significant influence over many ofour major customers in China, may contribute to volatility in the price of ourstock. In 2002, China Telecom completed its initial public offering, which hascaused that entity to issue press releases more frequently than in prior years.The price of our stock may react to such announcements. More recently, it hasbeen reported that China Netcom has been restructuring its operations for itsown initial public offering. More frequent public announcements from ChinaNetcom relating to or resulting from their initial public offering could causethe price of our stock to become even more volatile.

 

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***SOFTBANKCORP. and its related entities, including SOFTBANK America Inc., havesignificant influence over our management and affairs, which it could exerciseagainst your best interests.***

 

SOFTBANK CORP. and its related entities,including SOFTBANK America Inc. (collectively, “SOFTBANK”), beneficiallyowned approximately 12.8% of our outstanding stock as of March 31, 2004. As aresult, SOFTBANK has the ability to influence all matters submitted to ourstockholders for approval, as well as our management and affairs. Matters thatcould require stockholder approval include:

 

•                                          election and removal of directors;

 

•                                          merger or consolidation of our company; and

 

•                                          sale of all or substantially all of our assets.

 

This concentration of ownership may delay or prevent a change ofcontrol or discourage a potential acquirer from making a tender offer orotherwise attempting to obtain control of our company, which could decrease themarket price of our common stock.

 

***Delawarelaw and our charter documents contain provisions that could discourage orprevent a potential takeover, even if the transaction would benefit ourstockholders.***

 

Other companies may seek to acquire or mergewith us. An acquisition or merger of our company could result in benefits toour stockholders, including an increase in the value of our common stock. Someprovisions of our Certificate of Incorporation and Bylaws, as well asprovisions of Delaware law, may discourage, delay or prevent a merger oracquisition that a stockholder may consider favorable. These provisionsinclude:

 

•                                          authorizing the board of directors to issueadditional preferred stock;

 

•                                          prohibiting cumulative voting in the election ofdirectors;

 

•                                          limiting the persons who may call special meetingsof stockholders;

 

•                                          prohibiting stockholder action by written consent;

 

•                                          creating a classified board of directors pursuantto which our directors are elected for staggered three year terms; and

 

•                                          establishing advance notice requirements fornominations for election to the board of directors and for proposing mattersthat can be acted on by stockholders at stockholder meetings.

 

***The holders of our convertible subordinatednotes due in 2008 and we face a variety of risks related to the notes.***

 

Holders of our convertible subordinated notesdue 2008 (the “notes”) and we face a variety of risks with respect to thenotes, including the following:

 

•                                          we may be limited in our ability to purchase thenotes in the event of a change in control, either for cash or stock, whichcould result in our defaulting on the notes at the time of the change incontrol and purchases for stock would be subject to market risk;

 

•                                          an event of default under our senior debt,including one of our subsidiaries, could restrict our ability to purchase orpay any or all amounts due on notes, and after paying our senior debt in full,we may not have sufficient assets remaining to pay any or all amounts due onthe notes;

 

•                                          there is no listed trading market for the notes,which could have a negative impact on the market price of the notes;

 

•                                          we have significantly increased our leverage as aresult of the sale of the notes which could have an adverse impact on ourability to obtain additional financing for working capital;

 

•                                          hedging transactions related to the notes and ourcommon stock and other transactions, as well as changes in interest rates andour creditworthiness, may affect the value of the notes and of our commonstock; and

 

•                                          the notes might not be rated or may receive alower rating than anticipated by investors, ultimately having a negative affecton the price of the notes and of our common stock.

 

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**ITEM 3****—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKETRISKS**

 

We areexposed to the impact of interest rate changes, changes in foreign currencyexchange rates and changes in the stock market.

 

*Interest Rate Risk.*  Ourexposure to market risk for changes in interest rates relates primarily to ourinvestment portfolio. The fair value of our investment portfolio would not besignificantly affected by either a 10% increase or decrease in interest ratesdue mainly to the short-term nature of most of our investment portfolio.However, our interest income can be sensitive to changes in the general levelof U.S. interest rates since the majority of our funds are invested ininstruments with maturities less than one year. Our policy is to limit the riskof principal loss and ensure the safety of invested funds by generallyattempting to limit market risk. Funds in excess of current operatingrequirements are mostly invested in government-backed notes, commercial paper,floating rate corporate bonds, fixed income corporate bonds and tax exemptinstruments. In accordance with our investment policy, all short-terminvestments are invested in “investment grade” rated securities with minimum Aor better ratings. Currently, most of our short-term investments have AA orbetter ratings.

 

The table below represents carrying amountsand related weighted-average interest rates of our investment portfolio atMarch 31, 2004:

 
| **(in  thousands except interest rates)** |   |    |    |
|-------------------------------------------|--------|---------|---------|
|                                      |   |    |    |
| Cash and cash equivalents                 |   | $       | 724,939 |   |
| Average interest rate                     |   | 0.92    | %       |
| Restricted cash                           |   | 3,971   |    |
| Average interest rate                     |   | 0.48    | %       |
| Restricted short-term investments         |   | 26,893  |    |
| Average interest rate                     |   | 1.07    | %       |
| Short-term investments                    |   | 41,330  |    |
| Average interest rate                     |   | 1.35    | %       |
| Total investment securities               |   | 797,133 |    |
| Average interest rate                     |   | 0.95    | %       |
|                                           |        |         |         |  |

 

*Concentration ofCredit Risk and Major Customers:*The table below outlines our sales to, and theaccounts receivable balances with respect to our largest customers:

 
|     |   | **% of Net  Sales** |   | **% of  Accounts  Receivable** |   |
|----------|--------|---------------------|--------|--------------------------------|--------|
| **2004** |   |                |   |                           |   |
| A        |   | 24                  | %      | 15                             | %      |
|     |   |                |   |                           |   |
| **2003** |   |                |   |                           |   |
| B        |   | 14                  | %      | 1                              | %      |

 

The Company extends credit to its customersin China generally without requiring collateral. In global sales outside ofChina, the Company often requires letters of credit from its customers. TheCompany monitors its exposure for credit losses and maintains allowances fordoubtful accounts.

 

*Foreign Exchange Rate Risk.*  We are exposed to foreign currency exchangerate risk because most of our sales in China are denominated in Renminbi. Dueto the limitations on converting Renminbi, we are limited in our ability toengage in foreign currency hedging activities in China.  Beginning in the first quarter of 2004, wehedge certain Japanese Yen-denominated balance sheet exposures against futuremovements in foreign currency exchange rates by using foreign currency forwardcontracts. Gains and losses on these fair value hedges are intended to offsetgains and losses from the revaluation of our Japanese Yen-denominatedrecognized liabilities. In accordance with Statement of Financial AccountingStandards No. 133 (“SFAS 133”), “Accounting for Derivative Instruments andHedging Activities,” we recognize derivative instruments and hedging activitiesas either assets or liabilities on the balance sheet and measure them at fairvalue. The net result of gains and losses on contracts and revaluation includedin interest and other income (expense) was insignificant for the three monthsended March 31, 2004. Our foreign currency forward contracts generally maturewithin three months. We do not intend to utilize derivative financialinstruments for trading purposes. There were no foreign currency forwardcontracts held at March 31, 2004. Movements in currency exchange rates couldcause variability in our other income (expense).

 

Although the impact of currency fluctuationsof Renminbi to date has been insignificant, fluctuations in foreign currencyexchange rates in the future may have a material adverse effect on our resultsof operations. We maintain a bank account in Japanese Yen for purchasingportions of our inventories and supplies. The balance of this Japanese Yenaccount as of March 31, 2004 was approximately $43.1 million.

 

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**ITEM4****—CONTROLS ANDPROCEDURES**

 

Our management, including the Chief Executive Officer and the ChiefFinancial Officer, has conducted an evaluation of the effectiveness ofdisclosure controls and procedures, pursuant to Exchange Act Rule 13a-15(e) and15d-15(e) as of March 31, 2004.  Based on that evaluation, the ChiefExecutive Officer and the Chief Financial Officer concluded that our disclosurecontrols and procedures are effective in ensuring that all material informationrequired to be disclosed in this quarterly report has been made known to themin a timely fashion and no changes are required at this time.

 

In connection with the evaluation by our management, including theChief Executive Officer and Chief Financial Officer, of our internal controlover financial reporting, no changes during the quarter ended March 31, 2004were identified that could significantly affect our internal control overfinancial reporting subsequent to March 31, 2004.

 

**PART II****—OTHER INFORMATION**

 

**ITEM****1—LEGAL PROCEEDINGS**

 

On October 31, 2001, a complaint wasfiled in United States District Court for the Southern District of New Yorkagainst us, some of our directors and officers and various underwriters for ourinitial public offering. Substantially similar actions were filed concerningthe initial public offerings for more than 300 different issuers, and the caseswere coordinated as *In re Initial PublicOffering Securities Litigation*, 21 MC 92. In April 2002, aconsolidated amended complaint was filed in the matter against us, captioned *In re UTStarcom, Initial Public Offering SecuritiesLitigation*, Civil Action No. 01-CV-9604. Plaintiffs allegeviolations of the Securities Act of 1933 and the Securities Exchange Act of1934 through undisclosed improper underwriting practices concerning theallocation of IPO shares in exchange for excessive brokerage commissions,agreements to purchase shares at higher prices in the aftermarket andmisleading analyst reports. Plaintiffs seek unspecified damages on behalf of apurported class of purchasers of our common stock between March 2, 2000and December 6, 2000. Our directors and officers have been dismissedwithout prejudice pursuant to a stipulation. On February 19, 2003, theCourt granted in part and denied in part a motion to dismiss brought bydefendants including us. The order dismisses all claims against us except for aclaim brought under Section 11 of the Securities Act of 1933, whichalleges that the registration statement filed in accordance with the IPO wasmisleading. A proposal has been made for the settlement and release of claimsagainst the issuer defendants, including us. The settlement is subject to anumber of conditions, including approval of the proposed settling parties andthe court. If the settlement does not occur, and litigation against us continues,we believe we have valid defenses and we intend to defend the case vigorously.The total amount of the loss associated with the above litigation is notdeterminable at this time. Therefore we are unable to currently estimate theloss, if any, associated with the litigation.

 

We are a party to other litigation mattersand claims that are normal in the course of our operations, and while theresults of such litigation matters and claims cannot be predicted withcertainty, we believe that the final outcome of such matters will not have amaterial adverse impact on our financial position or results of operations.

 

**ITEM2—CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUERPURCHASES OF EQUITY SECURITIES**

 

(e) Stock repurchased for the quarter ended March 31, 2004 is asfollows:

 

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| **Period**                            |   | **Total  Number  of shares  purchased (1)** |   | **Average  purchase price  per share** |   | **Total  Number of shares  purchased as part of a publicly  announced program (1)** |   | **Maximum  number of shares  that may yet be purchased  under plans (1)** |   |
|---------------------------------------|--------|---------------------------------------------|--------|----------------------------------------|--------|-------------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------|--------|
|                                  |   |                                        |   |                                   |   |                                                                                |   |                                                                      |   |
| January 1, 2004 - January 31, 2004    |   | —                                      |   | —                                 |   | —                                                                              |   | —                                                                    |   |
|                                  |   |                                        |   |                                   |   |                                                                                |   |                                                                      |   |
| February 1,  2004 - February 29, 2004 |   | —                                      |   | —                                 |   | —                                                                              |   | —                                                                    |   |
|                                  |   |                                        |   |                                   |   |                                                                                |   |                                                                      |   |
| March 1,  2004 - March 31, 2004       |   | 2,568,000                                   |   | $30.43                                 |   | 2,568,000                                                                           |   | 4,055,000                                                                 |   |

 

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(1)**         **On March 12, 2004, the Company On March12, 2004, the Company announced a program to repurchase up to 5,000,000 sharesof its outstanding common stock over a period of six months, until September,2004 (the “Repurchase Program”). In addition, the Company announced therepurchased of an additional 1,623,000 shares of its outstanding common stockin a privately negotiated transaction with an institution (the “PrivateRepurchase”). The Private Repurchase was completed in March, 2004. “TotalNumber of Shares Purchased” and “Total Number of Shares Purchased as Part of aPublicly Announced Program” reflect the Private Repurchase and an additional945,000 shares repurchased pursuant to the Repurchase Program in March, 2004.

 

**ITEM 3—DEFAULTS UPON SENIOR SECURITIES**

 

[None.]

 

**ITEM 4—SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

[None.]

 

**ITEM5****—OTHERINFORMATION**

 

Our directors, officers, or employees haveentered, and may from time to time enter, into good faith trading planspursuant to SEC Rule 10b5-1(c).

 

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**ITEM6****—EXHIBITS ANDREPORTS ON FORM 8-K**

 

(a)                                  Exhibits:

 
| **NUMBER** |   | **EXHIBIT DESCRIPTION**                                                                                                        |
|------------|--------|--------------------------------------------------------------------------------------------------------------------------------|
| 10.97*     |   | Infrastructure Equipment License Agreement between  Qualcomm Inc. and UTStarcom, Inc., dated January 30, 2004                  |
| 10.98*     |   | Subscriber Unit License Agreement between Qualcomm  Inc. and UTStarcom, Inc., dated January 30, 2004                           |
| 10.99*     |   | Asset Purchase Agreement among Hyundai Syscomm,  Inc., 3R Inc., Dr. Seong IK Jang and UTStarcom, Inc., dated February 26, 2004 |
| 31.1       |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002                                                       |
| 31.2       |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002                                                       |
| 32.1       |   | Certification Pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002        |

 

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* Portions of the exhibit havebeen omitted pursuant to a request for confidential treatment filed with theSEC concurrently with the filing of this Quarterly Report on Form 10-Q.

 

(b)                                 Reportson Form 8-K:

 

1.               Report on Form 8-Kdated and filed on January 7, 2004 under Item 5 and Item 7, relating to theCompany’s 2003 Nonstatutory Stock Option Plan and the RollingStreams Systems,Ltd. 2001 Stock Plan which the Company assumed.

 

2.               Report on Form 8-Kdated and filed on January 13, 2004 under Item 5 and Item 7, relating to a formof Underwriting Agreement between the Company and Banc of America SecuritiesLLC and the First Amended and Restated Bylaws of the Company.

 

3.               Report on Form 8-Kdated and filed on January 22, 2004 under Item 5 and Item 7, relating to theCompany announcing its results of operation for the fourth quarter of 2003 andthe full year ended 2003.

 

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**UTSTARCOM, INC.**

 

**SIGNATURES**

 

                Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

 

 
|                    |   |   |   |   |   | UTSTARCOM, INC.

 

 

  |
|-------------------------|--------|--------|--------|--------|--------|-----------------------------------------|
| Date:  May 7, 2004 |   |   |   |   |   | By:                                     | /s/  Hong Liang Lu |
|                    |   |   |   |   |   |                                    | Hong Liang  Lu |
|                    |   |   |   |   |   |                                    | *President, Chief Executive Officer and Director* |
|                    |   |   |   |   |   |                                    | *(Principal Executive Officer)* |
|                    |   |   |   |   |   |                                    |   |
|                    |   |   |   |   |   |                                    |   |
|                    |   |   |   |   |   |                                    |   |
|                    |   |   |   |   |   |                                    |   |
| Date:  May 7, 2004 |   |   |   |   |   | By:                                     | /s/  Michael J. Sophie |
|                    |   |   |   |   |   |                                    | Michael J.  Sophie |
|                    |   |   |   |   |   |                                    | *Senior Vice President of Finance and Chief Financial Officer* |
|                    |   |   |   |   |   |                                    | *(Principal Financial Officer)* |

 

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**UTSTARCOM, INC.**

**EXHIBIT INDEX**

 
| **NUMBER** |   | **EXHIBIT DESCRIPTION**                                                                                                        |
|------------|--------|--------------------------------------------------------------------------------------------------------------------------------|
| 10.97*     |   | Infrastructure Equipment License Agreement between  Qualcomm Inc. and UTStarcom, Inc., dated January 30, 2004                  |
| 10.98*     |   | Subscriber Unit License Agreement between Qualcomm  Inc. and UTStarcom, Inc., dated January 30, 2004                           |
| 10.99*     |   | Asset Purchase Agreement among Hyundai Syscomm,  Inc., 3R Inc., Dr. Seong IK Jang and UTStarcom, Inc., dated February 26, 2004 |
| 31.1       |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002                                                       |
| 31.2       |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002                                                       |
| 32.1       |   | Certification Pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002        |

 

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* Portions of the exhibit havebeen omitted pursuant to a request for confidential treatment filed with theSEC concurrently with the filing of this Quarterly Report on Form 10-Q.

 

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